How to Calculate Loan Interest

Understanding how loan interest is calculated is essential for making informed financial decisions. Learn the differences between simple and amortizing interest, how each impacts your repayment, and the factors that determine your interest rate. By mastering these concepts, you can save money and secure better loan terms.

01.03.2023
1019
15 min.

To choose the best personal loan for you, you need to compare interest rates and know how they work. While loan calculators on lenders’ websites will give you a quick estimate, understanding the mechanics of interest calculation will help you make more informed decisions and avoid surprises.

How to Calculate Loan Interest

What Is Interest and Principal?

Interest is the cost of borrowing from a lender. It’s how lenders make money and is usually expressed as a percentage of the loan amount. The principal is your original loan amount, excluding interest and fees. How much you pay in interest depends on the type of loan, your credit score, loan term, and interest structure.

Lenders charge interest in two ways: simple interest and amortizing interest. Simple interest is where the amount of interest you pay remains the same throughout the life of the loan, as it’s calculated only on the initial loan amount (the principal). An amortizing loan is where your interest payments decrease over time as you pay down the principal, with a bigger portion of each payment going to the principal balance as the loan goes on.

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How to Calculate Interest on a Loan

Interest is calculated as a percentage of the loan amount. There are two ways interest can be calculated: simple interest and amortizing interest. Simple interest is calculated only on the principal amount, meaning the interest remains the same throughout the life of the loan. Amortizing interest is more common, and it’s calculated in such a way that you pay less interest as you pay down the principal over time. Knowing both will help you better understand how interest will affect the total amount you repay.

Simple Interest on a Loan

Simple interest is easy to calculate. You need to know your principal loan amount, interest rate, and loan term. Interest is calculated on the original principal and remains the same throughout the term.

Your monthly payment is fixed, but the interest you pay each month is based on the outstanding principal. If you pay off the loan early, you can save a lot of interest as long as there’s no prepayment penalty from the lender.

How to Calculate Simple Interest

Formula:

Principal x Interest Rate x Repayment Term = Interest Amount

For example, if you borrow $10,000 at 5% interest for 5 years, the simple interest formula would be $10,000 x 0.05 x 5 = $2,500 in interest.

Which Loans Use Simple Interest?

Simple interest is not common in traditional lending but can be found in some loans. Short-term loans like payday loans and car title loans use simple interest. Federal student loans also charge simple interest on the amount borrowed.

Simple interest isn’t common for most personal loans but can apply to some installment loans or personal loans. But it’s generally not found in standard lending practices.

Amortizing Interest on a Loan

Amortizing interest is more common and is used in loans like mortgages, personal loans, and auto loans. Early in the loan, most of your monthly payment goes to interest and only a small portion to the principal. As you pay down the loan, a bigger portion of your payment goes to the principal.

While your monthly payment remains the same, how it’s split between interest and principal changes. At the beginning, interest dominates; towards the end of the loan, most of your payment reduces the principal.

How to Calculate Amortizing Interest

  1. Divide your interest rate by the number of payments you’ll make that year. For example, if you have a 12% anul interest rate, and you make monthly payments, you would divide 0.12 by 12 to get 0.01

  2. Multiply that number by your outstanding loan balance to find out how much you’ll pay in interest that month. If you have a $6,000 loan balance, your first month’s interest would be $60.

  3. Subtract that interest from your fixed monthly payment to see how much of your payment goes toward the principal in the first month. If your lender has told you that your fixed monthly payment is $1,030.58, you will pay $970.58 toward the principal in the first month. That amount gets subtracted from your outstanding balance.

  4. Repeat the process with your new balance for the next month, and so on. To find out the total interest paid over the life of the loan, add up all the interest payments.

Amortization Calculations Breakdown

Here’s the breakdown of the amortization for a $6,000 loan at 12% annual interest for 6 months:

First Month
Interest: $6,000 x 0.01 = $60
Principal: $1,030.58 - $60 = $970.58
Balance: $6,000 - $970.58 = $5,029.42

Second Month
Interest: $5,029.42 x 0.01 = $50.29
Principal: $1,030.58 - $50.29 = $980.29
Balance: $5,029.42 - $980.29 = $4,049.13

Third Month
Interest: $4,049.13 x 0.01 = $40.49
Principal: $1,030.58 - $40.49 = $990.09
Balance: $4,049.13 - $990.09 = $3,059.04

Fourth Month
Interest: $3,059.04 x 0.01 = $30.59
Principal: $1,030.58 - $30.59 = $999.99
Balance: $3,059.04 - $999.99 = $2,059.05

Fifth Month
Interest: $2,059.05 x 0.01 = $20.59
Principal: $1,030.58 - $20.59 = $1,009.99
Balance: $2,059.05 - $1,009.99 = $1,049.06

Sixth Month
Interest: $1,049.06 x 0.01 = $10.49
Principal: $1,030.58 - $10.49 = $1,020.09
Balance: $1,049.06 - $1,020.09 = $28.97

Total paid to lender: $6,183.48.

Which Loans Use Amortizing Interest?

Amortizing interest is used for personal loans, mortgages, and auto loans. Other loans that may use this method are debt consolidation loans, home equity loans, and some student loans.

These types of loans have longer terms, so you pay more interest over time. Since early payments are mostly interest rather than principal, paying off the loan early will save you less interest compared to loans with simple interest.

Interest Rate Factors

  • Loan amount. The bigger the loan, the more interest you'll pay. Lenders view bigger loans as riskier, so they charge more interest. Bigger loans increase the risk of default, and lenders compensate for that risk by charging higher interest.

  • Credit score. Your credit score is a major factor in determining the interest rate on your loan. A higher score means lower interest rates, a lower score means higher interest rates.

  • Loan term. Shorter terms have higher monthly payments, but you pay less interest overall. Longer terms have lower monthly payments but extend the repayment period so you pay more interest in total.

  • Repayment schedule. Making more payments can reduce the interest you pay over time. If your loan has compounding interest, paying off the principal faster can save you a lot.

  • Payment amount. Paying more than the minimum payment can reduce your loan balance faster and save you interest. You can usually request that extra payments go towards the principal rather than future interest.

  • Credit history. Lenders check your credit history to see how you've paid your debts in the past. A good credit history with on-time payments can mean lower interest rates, poor history can mean higher rates.

  • Collateral. Secured loans like mortgages or car loans require collateral, which reduces the lender’s risk. Since the loan is backed by an asset, interest rates on secured loans are lower compared to unsecured loans, which are riskier for lenders.

How to Get the Best Interest Rates

  • Improve your credit score. To get the best interest rates, you need to have good to excellent credit score. Lenders offer the best rates to borrowers who have a history of on-time payments and low credit risk. Improving your score can make a big difference in the rates you’ll get.

  • Choose a shorter repayment period. The shortest terms usually have the best interest rates. If you can handle higher monthly payments, choosing a loan with a shorter term will not only save you interest but also pay off your loan faster.

  • Reduce your debt-to-income ratio. Your debt-to-income (DTI) ratio is a major factor in determining the rates you qualify for. This ratio is the percentage of your monthly income that goes to debt payments. A lower DTI ratio tells lenders you’re financially responsible and can handle more debt, which can mean better loan terms.

  • Compare offers. Don’t settle for the first offer you get. Each lender has different terms and rates can vary a lot. Prequalifying with at least 3 lenders will give you an idea of the best rates available without affecting your credit score. This way you can make an informed decision based on the best terms.

Average Personal Loan Interest Rates

Knowing your credit score will give you an idea of the interest rate you’ll get when you borrow. With a good to excellent credit score, you can get an APR that’s much lower than someone with a fair or poor credit score. Borrowers with good credit get rates at or below the national average, while those with fair or poor credit can get APRs similar to or even higher than credit card interest rates.

According to Bankrate, here are the average interest rates borrowers get based on their credit score:

  • Credit score 720-850 average loan interest rate 10.73%-12.50%

  • Credit score 690-719 average rates between 13.50%-15.50%

  • Credit score 630-689 average rates between 17.80%-19.90%

  • Credit score 629-300 average rates between 28.50% and up

Note! These are averages, use as a guide. Your actual rates may vary based on your credit history, loan amount, loan term, and lender’s policy.

Conclusion

Knowing how interest is calculated is key to making smart decisions. The choice between simple interest and amortizing loans will affect the total amount you pay, amortizing loans usually means higher total interest. Credit score, loan amount, and term can greatly impact the interest rate. Improving your credit score, choosing a shorter term, and reducing your debt-to-income ratio can get you better rates. Always compare offers from different lenders, rates can vary. While averages are a guide, your actual rate will depend on your financial profile and lender terms.

 

FAQ

What is a good interest rate for a personal loan?

A good interest rate for a personal loan is lower than the market rate, but what’s good is relative to your credit score. For those with excellent credit, rates below 11% are competitive, and rates above 12.5% may not be as good. To get the best rate, keep a good credit history by paying on time, low credit utilization, and minimal new credit inquiries. Also, compare offers from at least 3 lenders to make sure you’re getting the best terms.

What’s the difference between APR and loan interest rates?

The main difference between APR and interest rate is that APR includes not only the interest charged on the loan but also any additional fees such as origination or processing fees. So APR is usually higher than interest rate. The interest rate only reflects the cost of borrowing the principal, while APR gives you the total cost of the loan over the term.

Why do lenders offer different interest rates on personal loans?

Lenders set their rates based on the type of borrowers they target. Online lenders offer lower rates to borrowers with excellent credit and high incomes. Banks and credit unions offer better rates to their existing customers, especially those with big deposit balances. For those with fair or poor credit, you need to shop around, rates can vary greatly based on employment stability, loan term, and lender’s criteria. Some lenders offer better rates for shorter-term loans, especially to borrowers who can handle higher monthly payments.

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