When you take out a loan whether it is a school fees loan, personal loan, auto loan or mortgage–lenders earn money by charging you interest. Interest is the price you pay for borrowing money from a lender. That means you will not just pay back the money you borrowed. You will also pay back an additional sum, which is the interest on the loan.
Lenders take different approaches to charging interest. Some use what is known as a simple interest method, while others may charge interest based on an amortization schedule, which applies more interest during the early stages of the loan. Things like your credit history also affect the amount of interest you will ultimately pay, loan amount and loan terms. Here is how to calculate loan interest.
What is loan interest?
Interest is the price you pay to borrow money. If you take out a $20,000 personal loan, you may wind up paying the lender a total of almost $23,000 over the life of the loan. That extra $3,000 is the interest.
As you repay the loan over time, a portion of each payment goes toward the amount you borrowed (the principal), and another portion goes toward interest costs. How much loan interest the lender charges is determined by various factors, including your credit history, annual income, loan amount, loan terms and the current amount of debt you have.
Simple interest
If a lender uses the simple interest method, it’s easy to calculate loan interest if you have the right information available. You will need your principal loan amount, interest rate and the total number of months or years you will repay the loan to calculate the overall interest costs.
The monthly payment is fixed, but the interest you will pay each month is based on the outstanding principal balance. So, if you pay the loan off early, you could save a sizable amount in interest, assuming the lender doesn’t charge prepayment penalties.
Amortizing loans
Many lenders charge interest based on an amortization schedule. Student loans, mortgages and auto loans often fit into this category. The monthly payment on these types of loans is also fixed, and the loan is paid over time in equal installments. However, how the lender applies the payments you are making to the loan balance changes over time.
With amortizing loans, the initial payments are generally interest-heavy, meaning less of the money you pay each month goes toward your principal loan amount.
As time passes and you draw closer to your loan payoff date, however, the table turns. Toward the end of your loan, the lender applies the majority of your monthly payments to your principal balance and less toward interest fees.
How to calculate loan interest
To maximize their profits, lenders take different approaches to charging interest. Calculating loan interest can be difficult, as some types of interest require more math.
Simple interest
You can calculate your total interest by using this formula:
Principal loan amount x Interest rate x Time (Number of years in term) = Interest
For example, if you take out a five-year loan for $20,000 and the interest rate on the loan is 5 percent, the simple interest formula works as follows:
- $20,000 x .05 x 5 = $5,000 in interest
Factors that can affect how much interest you pay
Many factors can affect how much interest you pay for financing. Here are some primary variables that can impact how much you will pay over the loan life.
- Loan amount
The amount of money you borrow (your principal loan amount) greatly influences how much interest you pay to a lender. The more money you borrow, the more interest you’ll pay.
- Interest rate
Along with the amount of your loan, your interest rate is extremely important when it comes to figuring out the total cost of borrowing. Poorer credit scores typically mean you will pay a higher interest rate.
- Loan term
A loan term is the time a lender agrees to stretch out your payments. So if you qualify for a five-year auto loan, your loan term is 60 months. Mortgages, on the other hand, commonly have 15-year or 30-year loan terms.
The number of months it takes you to repay the money you borrow can significantly impact your interest costs.
- Repayment schedule
How often you make payments to your lender is another factor to consider when calculating interest on a loan. Most loans require monthly payments (though weekly or biweekly, especially in business lending). If you opt to make payments more frequently than once a month, there’s a chance you could save money.
- Repayment amount
The repayment amount is the dollar amount you must pay on your loan each month.
In the same way that making loan payments more frequently has the potential to save you money on interest, paying more than the monthly minimum can also result in savings.
Key Takeaway
If you are considering adding money to your monthly loan payment, ask the lender if the extra funds will count toward your principal. If so, this can be a great strategy to reduce your debt and lower the interest you pay.