When you borrow money, the lender will ask you to repay those funds over time. But banks expect to be paid something in exchange for their services and the risk they’re taking in lending you money. As a result, you won’t just pay back the money you borrowed. You’ll pay back the loan plus an additional sum, known as interest.
Interest is one of the primary ways that lenders, banks and credit card issuers earn a profit. Here’s a look at how interest works and how you can calculate the cost when you borrow money.
What is interest?
Interest is the price you pay to borrow money from someone else. If you finance a car for $20,000, you may wind up paying the lender a total of $25,000 over the next five years. That extra $5,000 is interest. As you repay your loan over time, a portion of each payment goes toward the amount you borrowed (the principal) and another portion goes toward interest costs.
How to calculate interest on a loan
Lenders take different approaches when it comes to the interest they charge. This can make calculating loan interest difficult. Some types of interest are easy to understand, while others require a bit more math.
If a lender uses the simple interest method, it’s easy to calculate the interest on your loan. You can use the following formula to figure out the cost of financing:
Principal Loan Amount x Interest Rate x Time (aka Number of Years in Term) = Interest
So if you take out a five-year loan for $20,000 and your interest rate is 5 percent, the simple interest formula works as follows:
$20,000 x .05 x 5 = $5,000 in interest
You might encounter simple interest on short-term loans. However, the way most banks and lenders charge interest is more complicated.
Many lenders charge interest based on an amortization schedule. Student loans, mortgages and auto loans often fit into this category. Your monthly payment on these types of loans remains fixed, but the way the lender applies the money you pay changes over time.
With amortizing loans, your initial payments are generally interest-heavy, and less goes toward your principal loan amount. As time passes and you draw closer to your payoff date, the table turns. Toward the end of your loan, the lender will apply the majority of your monthly payments to your principal balance and less toward interest fees.
Here’s an example of an amortization table for a $5,000, one-year personal loan with a 6 percent fixed interest rate.
$5,000 Personal Loan, 1-Year Repayment Term, 6% Fixed Interest Rate
|Payment Date||Payment||Principal||Interest||Total Interest Paid||Remaining Balance|
With larger loan amounts, the shift that takes place in your payment breakdown is more meaningful. Take a 30-year, $200,000 mortgage as an example. Assuming you have a fixed rate of 4.5 percent, your first payment of $1,013.37 would be split up as follows:
- $263.37 applies to principal
- $750.00 applies to interest
Now fast forward 30 years (and assume you never refinanced your home loan). Your lender will apply your final payment of $1,013.37 to your remaining balance in the following manner:
- $1,009.58 applies to principal
- $3.79 applies to interest
When your loan is amortized, your lender collects more interest upfront, but your monthly payment will remain consistent.
Factors that affect how much interest you pay
There are many factors that can affect how much interest you pay for financing. If you want to calculate how much interest you’ll pay over the course of a loan, you first need to gather the following details.
The amount of money you borrow (aka your principal loan amount) has a big influence over how much interest you pay to a lender. The more money you borrow, the higher your interest fees.
In the example mentioned earlier, you would pay $5,000 in interest on a five-year, 5 percent simple-interest loan for $20,000. If you keep all other loan factors the same (e.g., rate, term and interest type) but increase your loan amount to $30,000, the interest you pay over five years would increase from $5,000 to $7,500.
Along with the amount of your loan, the size of your interest rate is extremely important when it comes to figuring out the cost of borrowing. Building on the previous example, let’s compare a 5 percent loan with a 7 percent loan ($20,000, five-year term, simple interest).
On the 5 percent loan, you already know that the interest cost is $5,000 ($20,000 x .05 x 5 = $5,000). If the interest rate increases to 7 percent, the cost of interest rises to $7,000 ($20,000 x .07 x 5 = $7,000). Tip: One of the best ways to secure a lower interest rate is to work to improve your credit.
You will also need to find out whether your loan features a fixed interest rate or variable interest. The answer to this question will affect your overall cost of financing.
A loan term describes the amount of 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 have a significant impact on your overall interest costs. In general, shorter loan terms lead to higher monthly payments and less interest paid. Longer loan terms may reduce your monthly payment size, but they tend to increase your interest fees and, therefore, the overall cost of the loan.
How often you make payments to your lender is another factor to consider when you calculate interest on a loan. Most loans require monthly payments (though weekly or biweekly payments exist too, especially in business lending). If you opt to make payments more frequently, there’s a chance you could save money.
When you make payments more often, you may reduce your principal loan amount faster. In many cases, such as when a lender charges compounding interest, making extra payments could save you a lot.
Not only does paying more frequently have the potential to save you money in interest, but paying extra above the required minimum might also result in some savings. If you’re thinking about adding additional 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 amount of interest you pay.
The bottom line
Figuring out the true cost of interest on a loan or credit card can seem difficult. But in truth, once you know the type of interest you’re paying, you can use a financial calculator online that will help you crunch the numbers.
When it comes to credit cards and other loans, remember that paying off your balance faster can potentially save you a lot of money in interest fees. With credit cards in particular, paying your full statement balance by the due date each month usually helps you avoid interest altogether.