Before we jump into how loan interest is calculated and the factors that affect how much you pay in interest, let’s start with answering the question “What is loan interest?”.
What is Loan Interest?
Interest is the cost to borrow someone else’s money. If you borrow $30,000 from a lender, you’ll have paid almost $35,000 by the time your loan is finished. That’s a total of $5,000 that you paid the lender in loan interest.
When you borrow from a lender, a portion of your payments goes towards the capital and a portion goes towards interest. The amount of interest a borrower pays is determined by things like credit history, income, loan amount, and loan terms.
How is Loan Interest Calculated?
To make the most profit, lenders take different approaches to charging interest. Interest rates can be difficult to calculate, depending on the type of interest involved.
How to Calculate Simple Interest
It’s very easy to calculate loan interest when using the simple interest method. You’ll need to know your total monthly payment, your monthly interest rate, and the total number of months you’ll be paying the loan.
To calculate simple interest you use this formula: Loan Amount x Rate x Years = Interest.
100,000 x .04 x 10 = 40,000
If the principal on your loan is $100,000 at 4% over 10 years, you will pay $40,000 in interest over the life of the loan.
How to Calculate Amortizing Loans
Loans for homes, cars, or schools are all examples of amortization schedules. The monthly payment remains the same, but the lender applies these payments you make to the loan balance differently. For example, if your car loan has an amortization schedule the monthly payments remain the same, but the lender applies these payments you make to the loan balance differently.
A 30-year mortgage loan for $300,000 with an interest rate of 5% has a monthly payment at $1,610. For the first month, the $300,000 gets mulitplied 5% and you have $15,000. Divide $15,000 by 12 to get the $1,250 paid towards loan interest in your first monthly payment. The $360 that is left from the $1,610 is what gets taken off of the principal loan amount.
For the second month, the balance of $299,640 left on the principal after the first month is then multiplied by 5% and that number is then divided by 12 which gives you an amount that is less than the previous month getting put toward the interest on the loan. There are many online calculators that will give you a full breakdown of how these numbers pan out over the life of your loan.
What Determines How Much Interest is Paid?
It’s worth it to know how much interest you will pay for financing. There are many factors that can affect the amount of loan interest you pay over the life of the loan. Some of the most important variables include:
The Amount of the Loan
The size of the loan you take out has a significant effect on the amount of loan interest you’ll pay. The bigger the loan, the more interest you’ll need to pay. It’s simple to sum this up, the more money you borrow, the higher the risk for the lender. As the risk increases, the lender expects a higher return.
When borrowing money, it’s important to plan ahead. Borrowing more than you need usually only leads to more debt. Here are some tips for calculating your financial needs when borrowing money:
- Crunch the numbers
- Gather data on your financial resources
- Determine how much you really need to borrow
The Interest Rate of the Loan
The interest rate of a loan is just as important as the amount borrowed. People with poorer credit scores tend to have higher interest rates than those with good scores. Simply put, credit scores affect your interest rates with lenders.
Before you decide to take out a loan, find out what kind of interest rate your loan features. Is it fixed or variable? Fixed interest rates are stable and predictable, so your monthly or annual interest cost will not change over the lifetime of your loan. Variable interest rates are more likely to change, so the amount you owe to repay your loan can increase rapidly.
If you are borrowing money and you don’t have a great credit score, it might be wise to work on improving your score before applying. One way to improve your credit is to get a smaller personal loan and pay it off on time, which will help to boost your credit score. Improving your credit score can lead to better interest rates and lower monthly payments.
The Loan Repayment Schedule
When figuring out the rate of interest on a loan, you should consider how often you make payments. The vast majority of loans require monthly payments, but weekly or biweekly arrangements are also available. If you opt for a more frequent schedule, there’s a chance you’ll save money.
Making extra payments on your loan can reduce the principal owed on your loan, which could ultimately save you money. With compounding interest, making extra payments could be especially important and save you a significant amount of money.
The Loan Repayment Amount
The repayment amount is the dollar amount you’re required to pay on your loan each month. When you make larger monthly payments, it can save you money on interest charges. For example, if you pay $1000 instead of $750 per month, you’ll end up paying less in the long run.
If you’re thinking about increasing your monthly payment for a debt, make sure they count the additional funds as principal. If they do, this is a great strategy that will reduce your interest and your debt.
The Bottom Line on How Loan Interest is Calculated
It seems like a simple question: how much am I really paying in loan interest? In reality, it can take some work to arrive at the right answer. The good news is that once you know the type of loan interest you are paying, online financial calculators can help you crunch all the numbers. The calculator will show you a breakdown of the monthly, quarterly, and yearly costs of interest being paid on the loan.
When it comes to credit cards, loans, and other financial commitments, pay more than the minimum due each month if possible. You’ll save a ton of interest payments since these charges are calculated off the remaining balance. Credit cards are particularly good for this because you avoid interest charges if you pay your full statement balance by the due date.
