When you take out a loan–whether it’s a student 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 won’t just pay back the money you borrowed. You’ll also pay back an additional sum, which is the interest on the loan.
Lenders take different approaches to charging interest. Some use what’s 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. The amount of interest you will ultimately pay is also impacted by things like your credit history, loan amount and loan terms. Here’s 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.
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’ll 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.
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’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 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.
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
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
You might encounter simple interest on short-term loans. However, the way most banks and lenders charge interest is more complicated.
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 the principal for the first month. That amount gets subtracted from your outstanding balance.
- Repeat the process with your new remaining loan balance for the following month, 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|
Because calculating amortization schedules is fairly math-intensive, Bankrate has an amortization calculator that does all the work for you. Just enter the initial amount, the number of months and the interest rate and the calculator will determine your monthly payment.
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.
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.
“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 much money you require.
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.
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 determine whether your loan features a fixed or variable interest rate. If it’s variable, your interest costs could fluctuate throughout your loan and affect your overall cost of financing.
Takeaway: It may make sense to improve 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 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.
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, a 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 review the numbers ahead of time and figure out how much of a payment you can afford each month. 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, 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 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.
Takeaway: If you’re 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.
How to get the best loan interest rates
You may be able to improve your chances of obtaining the most favorable interest rate on a loan in a few ways.
Improve 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 debt you pay each month as a percentage of your gross monthly income. It is nearly as significant as your credit score when 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
Before taking out a loan, it’s vital to calculate how much you’ll pay in interest to understand the true borrowing costs. Ask the lender if interest is assessed using the simple interest formula or an amortization schedule, and use the appropriate formula or an online calculator to run the numbers.
Also, be mindful of the factors that will affect the interest you pay. It may be worthwhile to borrow less or shorten the repayment term to keep more of your hard-earned money in your pocket. Furthermore, you should improve your credit score before applying and shop around to ensure you get the best deal on a loan.