How to Calculate Loan Interest?

ByG. Dautovic
January 26, 2022

The pandemic waves ravaged the economy and people’s prospects, but those who have been stashing cash under their mattresses are relatively secure. However, many people weren’t that far-sighted and ended up reaching out to banks for loans. When paying them back, they have to cover the money they borrowed and the interest on the principal.

We’re here to teach you how to calculate loan interest so that you can plan your future with certainty. Let’s get started.

What Is Interest?

We’re all familiar with the concept of borrowing money from the bank or some other financial institution and paying it back over time in installments. If you’re looking for an official definition, we can put it like this: Interest is a fee paid regularly at a particular rate for the use of assets lent (usually) from a bank or other financial institution.

The bank earns by collecting interest on loans, and you are paying for borrowing and using the bank’s money.

Now, here’s the catch: Interest means you’ll need to pay back more than the original loan you took, as you’ll have to factor in the cost of borrowing the funds. The amount of interest you have to pay back depends on an interest rate, which in turn depends on your credit history, income level, type of loan, the overall amount of debt you already have, and other variables.

To calculate interest on a loan, you took out and its monthly payments, you’ll need basic math skills or an online loan calculator. Once you get all the figures, you can start planning your next purchase.

How Much Will You Pay?

As we’ve already mentioned, numerous variables determine the total you’ll have to part with on your way to paying off your loan. Let’s break down some of the most critical factors:

Principal Amount

The principal amount represents the funds you’re planning on borrowing from a bank. Its impact on the interest on the loan you took is simple: The more you borrow, the higher the interest is, as the lender is assuming a greater risk. It would be ideal to work out the numbers before you borrow and squeeze more money out of your budget to lessen the loan.

Here’s an example: If the initial size of the loan is $300,000 and the interest rate is 15%, the total sum you’ll have to pay at the end of the contract would be $345,000. However, if you’re borrowing less money, your interest amount would be lower, and you won’t have to pay back as much in the end.

Loan Term

When trying to figure out how to calculate interest on a loan, you’ll have to take into consideration the time you’re willing to spend paying the debt. If you decide to stretch out your payments on 30 years (e.g., for a mortgage), your monthly installments will be lower.

However, longer loan terms also mean that the interest you pay will be higher, and the total sum you’ll pay in the end will be bigger. That’s why shorter loan terms are better in the long run. Yes, you will have higher monthly payments, but you’ll incur less interest and pay less in the end.

Repayment Schedule

Another factor that helps you calculate total interest on a loan and estimate your costs is the schedule for your repayment. Whether you choose to repay weekly, fortnightly, or monthly can be a game-changer. Most borrowers pay installments once a month, as it fits the month-oriented budgeting style.

However, if you opt for weekly or biweekly payments, you could actually save money. Namely, more frequent repayments incur less interest because there’s less time for it to compound. You can reduce the principal that you own faster by paying more often.

Repayment Amount

As discussed in the “loan term” section, shorter loan terms mean higher monthly payments, but lower interest overall. When calculating interest on a loan, always ask the lender whether the additional payments you’re willing to make will count toward your principal.

If the answer is positive, you can start planning to chip away at your loan principal, thus reducing your debt and interest.

Interest Rate

Finally, we’ve come to the most important factor determining how much you will pay. The banks calculate your interest rate according to your credit score, overall debt, income level, type of loan, and a few other things. Once the lender gives you an interest rate, make sure to check whether it’s variable or fixed, as it can make all the difference.

Paying the loan with a fixed interest means that the rate remains the same for the life of the loan. On the other hand, a variable rate loan means that you’ll be charged depending on the changes in the market, which can elevate the costs, but also lower them significantly (which is why this is attractive at all). Variable-rate loans are better-suited to those who intend to pay their loan off quickly, as the market won’t have much time to fluctuate.

Calculating Loan Interest

Now that you know all the factors contributing to the total costs, let’s do the math to figure out your monthly payments.

Simple Interest

For this type of calculation, a borrower will need to gather the following information: The interest rate, principal loan amount, and loan term expressed in the number of moths or years. The loan interest formula goes like this:

Principal loan amount × Annual interest rate × Term = Total Interest

For example, if you’re taking a $20,000 loan with an annual interest rate of 8% and plan to pay it off within three years, here’s how to calculate the simple interest:

20,000 × 0.08 × 3 = $4,800

The total sum you owe to the bank aside from the principal amount would be $4,800, and altogether, that’d make $24,800.

This basic calculation can only give you a general idea of how much you’ll pay, as things are rarely that simple and usually include other variables that make the equation more complicated.

Amortization

If you’ve ever considered taking student loans, car loans, or a mortgage, you’ve probably heard of amortization. Before we go into details on how to calculate interest on a loan of this kind, let’s further explain it. Amortized loans have a fixed payment plan and equal installments.

However, lenders apply your payments differently over time. In the beginning, more of the money you are paying each month goes toward paying your interest. Over time, the balance shifts, and the lender starts to apply the majority of your monthly payments to your principal loan.

If this sounds overwhelming, we’ll help you work out the numbers using this simple interest payment formula:

(Interest rate ÷ the number of payments) × remaining loan balance = Monthly interest paid

You’ll have to divide your annual interest rate by the number of payments you’re planning on making that year. To determine how much interest you’ll pay that month, multiply the number you get by your remaining loan balance.

For example, if you have a 6% fixed interest rate on a loan of $5,000 and a loan term of one year, here’s how much you’ll have to pay in the first month:

(0.06% ÷ 12) × 5,000 = $25

The result you’ve got is the amount of money you’ll pay as interest on a loan in the first month of your payment term. However, as we’ve mentioned, amortized loans change priorities over time, so the amount of money you’ll pay as interest will decrease, and more money will be used to cover the principal.

To get figures for other months, simply subtract that interest from your fixed monthly installment to see how much money will go towards the principal. You can find a loan repayment calculator online to do the math for you, too.

Here’s an example: If your monthly installment is $430.33, you’ll pay $405.33 for the principal. Now, repeat the calculation with the new remaining loan balance you got for each subsequent month.

The amount of money you’ll pay to cover the interest on a loan will decrease down to only $2.14 in the last month of the term, whereas the money that’ll go to cover the principal will increase to $428.19 in the end.

How to Get the Best Rates

Now that you know how to calculate loan interest, you can try to boost your prospects of getting reasonable rates. As already mentioned, banks will estimate the risk they’re taking when lending you money and formulate the loan accordingly. There are some tips and tricks that will help you get the most favorable interest rate, though.

  • First of all, you should work on improving your credit score and keep it above 740, as this will make you appear more trustworthy and let you access better loan options. If your credit score is very low, you can try boosting it using credit help providers or go for signature loans instead.
  • Go for a short loan term, as shorter debt repayment times secure the best interest rates. We know it’s next-to-impossible when it comes to home loan rates, as purchasing a property requires many years of payback. However, generally speaking, shorter terms mean higher monthly payments, but lower total interest.
  • If you want to qualify for a competitive loan with reasonable interest rates, you should also work on your debt-to-income ratio (DTI). The DTI is the percentage you get when dividing all your monthly debt payments by your gross monthly income. If your debts are piling up, it’s less likely you’re going to be granted a loan, or at least one you want. Before applying, try to pay off your debts or at least consolidate them with another loan.

Bottom Line

We hope we shed some light on these complicated financial issues and that you now understand how to calculate loan interest. We paid special attention to the variables that impact the interest rate and gave you suggestions for boosting your loan potential. We presented you with a formula that’ll help you calculate the exact figures, too. 

If you don’t feel confident working out the numbers on your own, there’s a list of online calculators that can do it for you. Before you venture on this financial journey, consider your budget and think about any potential life change, such as moving or having kids. Once you get a loan, be punctual with your monthly installments.

FAQ

What is the formula to calculate interest on a loan?

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Here’s how to calculate the interest rate on a loan using the basic formula. It calls for multiplying your principal loan amount by your annual interest rate and time for paying the debt expressed in years.

How is interest calculated monthly?

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To get your monthly interest, simply divide the annual interest rate by 12. In the case of amortized loans, the lender will apply your payments differently over time. In the beginning, your installments will primarily go towards paying your interest. Over time, the majority of your monthly payments will go towards your principal. The formula is a bit different:

(Interest rate ÷ the number of payments) × remaining loan balance = interest paid out that month

How do you calculate interest - example?

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When determining how to calculate interest on a loan, you need to have all the data: The principal amount, annual interest rate, and loan term expressed in years. For example, if you’re taking a $30,000 loan with an annual interest rate of 6% and plan to pay it off within two years, you’ll calculate the interest rate using the formula:

$30,000 × 0.06 × 2 = $3,600

The total sum you’ll pay in the end combines the principal loan you took with the interest rate, making the total $33,600.

About author

I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.

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