Calculating Loan Interest - All You Need To Know
When lenders offer money to borrowers, they are providing a service and taking a risk, for which they expect something in return. There is always a risk associated with lending, which lenders cover by charging a sum of money, known as interest.
Let us consider that you borrow $30,000 for an auto loan and end up paying $40,000 while clearing the debt. The extra sum of $10,000 here is the interest, which you have paid throughout the loan term.
When you repay the debt through monthly payments, a portion of it covers the interest amount, and the remainder covers the principal.
How To Calculate Interest
The approach to calculating rates varies with each lender so it might be difficult to calculate the exact amount that you might have to pay. Some methods are easier to understand, while others can be confusing. Detailed below are two methods.
Simple Interest Method
This is one of the simplest methods of calculating interest on a loan. You calculate it by multiplying the interest rate and the payment term.
SI = P×I×N
Here, P stands for principle, I for interest rate, and N for the number of years in the term.
An auto loan is a common example where lenders use this method. If your lender also uses this method, it will be easier for you to calculate the interest amount for a loan you are planning to borrow.
Let us assume that you borrow an auto loan of $30,000 for five years at an annual interest rate of 5%.
You can calculate the amount with the help of this loan interest formula.
$30,000 (P) x 0.05 (I) x 5 (N) = $7,500.
Amortization Method
- The usage of an amortization schedule among lenders is very common. Mortgages and student loans are some common examples of this approach to interest payments.
- You will need to continue making fixed monthly payments towards clearing the debt. However, lenders often change the way they apply the money towards clearing the debt.
- The initial payments you make usually involve a large amount of interest with a negligible sum going towards the principal. The situation reverses when you are closer to the payoff date.
Here is a common example of an amortization method below. Let us assume that you borrow a personal loan of $4,000 for one year at a rate of 6%.
Date | Interest | Principal | Balance |
Jun, 2020 | $20 | $324 | $3,676 |
Jul, 2020 | $18 | $326 | $3,350 |
Aug, 2020 | $17 | $328 | $3,022 |
Sep, 2020 | $15 | $329 | $2,693 |
Oct, 2020 | $13 | $331 | $2,362 |
Nov, 2020 | $12 | $332 | $2,030 |
Dec, 2020 | $10 | $334 | $1,696 |
2020 | $106 | $2,304 | $1,696 |
Jan, 2021 | $8 | $336 | $1,360 |
Feb, 2021 | $7 | $337 | $1,023 |
Mar, 2021 | $5 | $339 | $683 |
Apr, 2021 | $3 | $341 | $343 |
May, 2021 | $2 | $343 | $0 |
2021 | $26 | $1,696 | $0 |
What Determines How Much Interest You Pay?
Here are five factors that determine how much extra you pay for the money you borrow.
- Principal - Interest payments increase along with the sum you borrow, otherwise known as the principal. If you borrow $30,000 for five years at a rate of 5%, you will have to pay $7,500 in interest. If you increase the loan sum to $40,000, keeping all other factors the same, you will have to pay $10,000 in interest over the life of the loan.
- Interest Rate - Let us consider the above example and increase the rate from 5% to 10%, keeping other terms the same. The interest amount paid over the life of the loan will double to $15,000. Accordingly, it is important to have a good credit score to secure a loan with the lowest rate.
- Term - When you have a short-term loan, you need to make higher monthly payments, but pay less interest overall. With a long-term loan, you can make lower monthly payments, but you will see an increase in the interest total paid. This increases the overall cost of borrowing.
- Schedule - You need to make monthly payments in most cases, but there are also weekly or biweekly options for certain loan types. You can expect to save money if you repay more often, which will bring down the principal quickly.
- Early Repayment - Some lenders might allow you to add an extra amount to the monthly payments you make. If that money goes towards your principal amount, you can lower the amount of interest paid over time and eliminate the debt early.
Bottom Line
Calculating borrowing costs can become easier if you know what type of interest you will be paying. Lenders often consider additional factors while calculating the amount, so it is important to ask them how they are making the calculation. It is advisable to pay off your loan at the earliest opportunity to avoid spending extra time paying interest.