When you borrow money, the lender will ask you to repay those funds over time. But banks expect to be paid something for their services and the risk they take when lending you money. That means 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 of borrowing money.
What is loan interest?
Interest is the price you pay to borrow money from someone else. If you take out a $20,000 personal loan, you may wind up paying the lender a total of almost $23,000 over the next five years. 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 (which is the principal) and another portion goes toward interest costs. The loan interest charged is determined by things like your credit history, income, loan amount, loan terms and current amount of debt.
How to calculate loan interest
In order to maximize profits, lenders take different approaches when it comes to charging interest. Calculating loan interest can be difficult, as some types of interest require a bit more math.
If a lender uses the simple interest method, it’s easy to calculate loan interest if you have the right information available. Gather information like your principal loan amount, interest rate and total number of months or years that you’ll be paying the loan.
Calculation: You can calculate your total interest by using this formula: Principal loan amount x Interest rate x Time (aka Number of years in term) = Interest
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
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. The monthly payment on these types of loans remains fixed and the loan is paid over time in equal installments, but the way the lender applies the payments you’re making to the loan balance changes over time.
With amortizing loans, the initial payments are generally interest-heavy, meaning less of the money you are paying each month goes toward paying 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.
Calculation: Here’s how to calculate the interest on an amortized loan:
- Divide your interest rate by the number of payments you’ll make that year. If you have a 6 percent interest rate and you make monthly payments, you would divide 0.06 by 12 to get 0.005.
- Multiply that number by your remaining loan balance to find out how much you’ll pay in interest that month. If you have a $5,000 loan balance, your first month of interest would be $25.
- Subtract that interest from your fixed monthly payment to see how much in principal you will pay in the first month. If your lender has told you that your fixed monthly payment is $430.33, you will pay $405.33 toward principal for the first month. That amount gets subtracted from your outstanding balance.
- For the following month, repeat the process with your new remaining loan balance, and continue repeating for each subsequent month.
Here’s an example of how a $5,000, one-year personal loan with a 6 percent fixed interest rate amortizes:
|Payment Date||Payment||Principal||Interest||Total Interest Paid||Remaining Balance|
Factors that can affect how much interest you pay
There are many factors that can affect how much interest you pay for financing. Here are some of the primary variables that can impact how much you will pay over the life of the loan.
The amount of money you borrow (your principal loan amount) has a big influence on how much interest you pay to a lender. The more money you borrow, the more interest you’ll pay.
“For larger loans, the lender is assuming greater risk. Hence, the lender seeks a higher return,” says Jeff Arevalo, financial wellness expert for GreenPath Financial Wellness.
If you borrow $20,000 over five years with a 5 percent interest rate, you’ll pay $2,645.48 in interest on an amortized schedule. 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 to $3,968.22.
Takeaway: Don’t borrow more than you need to. Crunch the numbers first and determine exactly how money you really require.
Along with the amount of your loan, your interest rate is extremely important when it comes to figuring out the cost of borrowing. Poorer credit scores typically equal higher interest rates.
Building on the previous example ($20,000, five-year term, amortized interest), let’s compare a 5 percent loan with a 7 percent loan. On the 5 percent loan, the total interest cost is $2,645.48. If the interest rate increases to 7 percent, the cost of interest rises to $3,761.44.
You’ll also need to find out whether your loan features a fixed interest rate or a variable interest rate. If it’s variable, your interest costs could rise over the course of your loan and affect your cost of financing.
Takeaway: It may make sense to work on improving your credit score before borrowing money, which could increase your odds of securing a better interest rate and paying less for the loan.
A loan term is 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 interest costs.
Shorter loan terms generally require higher monthly payments, but you’ll also incur less interest because you’re minimizing the repayment timeline. Longer loan terms may reduce the amount you need to pay each month, but because you’re stretching repayment out, the interest paid will be greater over time.
“The problem with long-term loans is that they significantly increase the total cost of the loan,” says Michael Sullivan, personal financial consultant for Take Charge America, a nonprofit credit counseling and debt management agency. “Long-term loans are the enemy of wealth building.”
Takeaway: Be sure to crunch the numbers ahead of time, figure out how much of a payment you can afford each month and find a loan term that makes sense for your budget and overall debt load.
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 payments exist too, especially in business lending). If you opt to make payments more frequently than once a month, there’s a chance you could save money.
When you make payments more often, it can reduce the principal owed on your loan amount faster. In many cases, such as when a lender charges compounding interest, making extra payments could save you a lot.
“If you’re going to make additional payments each month, check with your lender to make sure those payments are in fact going towards paying down the principal,” says Steve Sexton, financial consultant and CEO of Sexton Advisory Group. “If your loan is amortized, the more money paid to reduce the principal, the less interest you will pay.”
Takeaway: Don’t assume you can only make a single monthly payment on your loan. If you want to reduce the overall interest you pay to borrow money, it’s a good idea to make payments more often than required.
The repayment amount is the dollar amount you’re required to 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.
Takeaway: If you’re thinking about 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 amount of interest you pay.
How to get the best loan interest rates
There are various ways to improve your chances of obtaining the most favorable interest rate on a loan. They include:
Improving your credit score: The most competitive interest rates are generally available to those with the highest credit scores. “Keep your credit score above 740,” says Jay Ferrans, president of JM Financial & Accounting Services. “Maintaining a good credit score will allow you to access better loan options because you’ve demonstrated credit trustworthiness.”
Opt for a shorter repayment timeline: The best interest rates are always going to accompany the shortest-term loans. “If you can afford the payment that comes with a shorter loan, it is generally the best way to go,” Ferrans says.
Reduce your debt-to-income ratio: Your debt-to-income (DTI) ratio is the amount of debt you have to pay each month as a percentage of your gross monthly income. It is considered nearly as significant as your credit score when it comes to qualifying for a competitive loan. “Take steps to improve your debt-to-income ratio,” Sexton says. “By paying down your debt and lowering your DTI ratio, you could qualify for a lower interest rate with new debt or when you’re refinancing existing debt.”
The bottom line
Figuring out the true cost of interest on a loan or credit card can seem difficult. But 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 your balance off faster could 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.
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