How to Calculate Interest on a Loan?

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A Caucasian with beard man standing while catching a dollar coin from money tree. Dollar signs growing on branches and falling from tree. A contemporary style with pastel palette soft blue tinted background with desaturated clouds. Vector flat design illustration. Horizontal layout. Source: Depositphotos

Getting a loan itself can be pretty stressful. You need to weigh all the pros and cons, calculate your budget, and determine the required loan amount and how long you will have to pay it. And when everything seems clear, interest rates appear. Interest is paid in addition to the principal repayment. The question of how to calculate a payment with interest arises for almost everyone who takes a loan for the first time. There is a simple loan payment calculator for this, so it will help you calculate the interest rate on loan without much stress. 

Don’t panic if the calculating interest on a loan seems complicated. It’s actually not too easy, but you just need to be patient. Online calculators will do everything for you, but even after using them, you still have questions – that’s fine. In this case, you can contact your lender to describe to you in detail the scheme by which interest is charged specifically on your loan. Feel free to ask questions because the monthly payment and annual percentage rate (APR) depend on interest rates.

But let’s start from the beginning.

What Does Interest Rate Mean?

You pay for the use of other people’s money with an interest rate. They are a percentage of the amount of the loan that you took out and are, in fact, the income of your lender. So it doesn’t matter if you take a loan from a bank, credit union, or private lender – interest rates will always haunt you.

If your loan amount is $5,000, you will always pay more. How much more depends on a number of factors, such as the type of loan, loan term, lump sum, and so on.

Annual Percentage Rate vs. Interest Rate

It’s really hard to get confused about all these percentages, so let’s be clear. 

The interest rate shows only the value of the interest on the loan. However, rarely is the cost of a loan limited to just that. Along with the loan, most often comes a number of fees, such as an application fee or origination fee.

APR is the sum of all interest, fees, and other expenses you need to pay. That is, the interest rate plus any fees charged by the lender. This is the final cost of the loan and exactly what you need to pay attention to when calculating the future costs of a loan.

What Affects the Interest Rate?

To calculate loan interest, you need to clearly understand how they are formed and what they depend on. A lender charges interest rates based on competitive rates and the borrower’s ability to pay, so interest rates vary. This is where your credit history comes into play. The better it is, the lower the interest rate you may be offered for unsecured loans. A credit score shows lenders how much they can trust you and whether you are a reliable borrower.

When it comes to secured loans (car loans, for example), it’s a bit easier. When the lender has your collateral, it is easier for him to trust you. In case you fail your monthly payments, his money is safe – he will simply take your collateral. But when it comes to unsecured loans, the focus is on the credit score. So the lender understands that there is less risk and therefore reduces the interest on the loan.

How much interest you pay depends on the principal amount, loan term, repayment schedule, and repayment amount. 

Principal Amount

The loan principal is an amount you actually need and borrow without fees and interest rates. When you’re going to borrow money, think about how much you can afford based on your income and expenses.

Speaking about interest rates, the smaller the amount you borrow, the less interest you will have to pay. 

For example: borrowing $20,000 with a five years term and a 5% interest rate will cost you $2,645.48 in interest. And if the loan amount becomes $30,000 under the same conditions, you will pay $3,968.22.

Loan Term

The loan terms are no less important than the amount of the loan. The term of the loan shows how long you can extend your monthly loan payment. For example, you can repay an auto loan for five years, or it can be up to 15 to 30 years for a mortgage. 

When you choose a shorter loan term, your monthly payments will be higher. But you will get lower interest rates in the long run. However, when it comes to long term loans, it’s the other way around. You’ll get lower monthly payments but pay more interest. So the number of months you take out a loan can greatly impact your interest costs.

For example, if you get $20,000 at 8.75% p.a., you would pay $2,812 in interest over three years or $4,765 in interest over five years.

Repayment Schedule

The loan repayment schedule also determines how much money you spend or save. Most often, loans require a monthly payment. But there are often other options – you can pay weekly or biweekly. From the point of view of savings, it is more profitable to pay more often. If the lender charges compound interest, the more often you pay, the less the amount becomes, and the less the interest rates become. But it would be best if you always were sure that your income would allow you to make weekly payments.

Repayment Amount

When you make your payments, not all of them go towards repaying the loan itself. First, part of this money goes to pay interest, and the rest goes to the loan amount. 

To save money, you can pay more than the designated payment amount. Most importantly, make sure that your contract does not provide for prepayment penalties for early repayment of the loan. The lender may provide a prepayment penalty just in order not to lose the number of interest rates that you will be required to pay over the life of the loan.

Types of Loan Interest Rates

First of all, interest can be fixable or variable. A fixed interest rate means that you will pay the same amount of interest over time. A variable interest rate means the rate may change depending on what the big banks will publish interest rates.

Secondly, interests can be simple and compound. 

Simple Interest 

When you deal with simple interest, your first payment is for that month’s interest rate. After that, the remaining monthly payments are intended to reduce the loan amount itself. Most often, lenders prefer the simple interest method.

To calculate simple interest, you can use the following formula:

Principal amount x Interest rate x Time (Loan term) = Total interest you pay. 

Compounding Interest

Compounding interest is calculated not only based on the principal balance but also based on interest that has been accumulated in previous periods. Interest can be added to the loan’s lump sum on a monthly, quarterly, semiannual, or annual basis. The rate at which compound interest accrues depends on the frequency of compounding. The higher the number of compounding periods, the greater the compound interest. 

The formula for calculating compound interest is:

 x = P (1+r/n)nt – P. 

There are X for interest rate, P is for the principal amount, r is for annual interest rate, n is for the number of compounding periods, and t is for the time for which you borrow money. 

How to Calculate Total Interest

Each type of loan has its own way of calculating interest. In addition, the calculations depend on the type of interest the lender offers you. Often, you can easily find an online calculator and not bother with it – you just need to enter the necessary indicators and get the result.

Personal Loans

A personal loan, like a car loan or a house loan, is amortizing. In an amortization loan, payments are made on both principal and interest. First, amortized loans payment covers the interest on the loan. After that, the rest goes to reduce the loan amount. That is, the interest portion of the monthly payment will depend on the amount that you have left to pay off. Usually, the lender provides you with an amortization schedule that shows your monthly payment, how much of the repayment covers the principal, and how much covers the interest. Most loans usually do not require a down payment unless it’s an auto loan.

Here’s a short guide on how to calculate interest on an amortized loan:

  • Share out your interest amount by the number of your annual loan payments,
  • Multiply your remaining loan balance by the result you’ve got in the first step to see what interest amount you will pay that month,
  • Subtract the result you’ve got in step 2 from your monthly debt payment to find out what your loan principal repayment amount will be in the first month,
  • Repeat the actions above with your remaining principal for further calculation.

Let’s take an example of a $1,000 loan that is taken out for 12 months with a 15% interest rate. The monthly payment will always be $90.26. But there are differences between principal payment, interest payment, and total interest. In the first month, the principal payment will be $77.76, the interest payment – will be $12.50, and the total interest – will be $12.50. The final month’s principal payment will be $89.14, the interest payment – will be $1.11, and the total interest – will be $83.10. You can also use a loan calculator for amortizing loans to avoid mistakes and make life a little easier.

The Average Interest Rate on a Personal Loan

As already mentioned, interest rates depend on several factors. For personal loans, state, credit score, debt-to-income ratio, credit history, and loan term affect how much interest you pay. Often banks and credit unions offer lower rates than private lenders.

According to the Federal Reserve, the average interest rate for a 24-month personal loan was 10.16% in August 2022. 

But in the case of personal loans, you should always keep in mind the impact of the credit score on the interest rate. The lower the credit score, the higher your interest rates. 

Credit Card Interest Rates

In many ways, credit card interest is similar to personal loans, but there are a few differences. First, there is usually a minimum payment to pay off credit card debt. It can be either a percentage of the card balance or a fixed amount. But do not trust the minimum payments – often, they do not even cover the interest rate. So it’s better to pay more. If the minimum payment is based on your card balance, then try not to make purchases before paying it – otherwise, it will become higher. In general, in order to avoid high interest, it is worth maximizing the balance on your card: principal and interest are directly related.

Interest-only Loans

Interest-only loans are not very popular, but they do exist, and they can be helpful in some cases. The essence of this type of loan is that your monthly payment will be solely interest. You will not repay the loan at all. But you will need to pay back the total loan amount at the end of the loan term. 

Bottom Line

You will always be forced to pay interest, no matter what type of loan you choose. It doesn’t matter if it’s a secured loan or an unsecured loan, a personal loan, or a credit card. It doesn’t even matter where exactly you took the loan: banks, credit unions, and private lenders still charge interest on the loan. 

How high the rates are will depend on several factors, like the state where you live, the average bank rate, but, most of all, you. More precisely, your credit history and credit rating. For example, the average interest rate for a person with an excellent score (720-850) will be 12.5%, and for a person with a poor score (300-629) – 32%. 

In order to calculate the interest on a loan, there are formulas for each type of interest. If you are good at math and you like calculating interest – you can do it yourself. But if you do not want to bother once again – use the loan calculator.

So before you take out a loan, make sure you understand the total cost. Find out about your amortization schedule or another formula by which payments and interest will be calculated. Calculate the total interest on the loan and be ready to pay it off. Make sure that the loan repayment period and the number of payments per month are suitable for you and that your budget can afford it.