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When you take out a loan, lenders earn money by charging interest. In other words, interest is the price you pay for borrowing money from a lender. That means, when paying back the loan, you’ll pay the amount you borrowed plus an additional sum — which is the interest.
Lenders take different approaches to charge 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. Additional factors that impact the amount of interest you pay include credit history, loan amount, and loan terms. Here’s how to calculate loan 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’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.
You can calculate your total interest by using this formula:
- Principal loan amount x interest rate x loan 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 would be $20,000 x .05 x 5 = $5,000 in interest.
Who benefits from simple interest
Borrowers who make on-time or early payments benefit from simple interest. Because interest is calculated based only on the loan principal, borrowers can save with these loans as opposed to those with compound interest.
Types of loans that use simple interest
While simple interest is less common, you might encounter this form of interest on short-term loans, as well as some personal loans and even vehicle loans There are also some mortgages that charge simple interest. Those with student loans may also pay simple interest. For instance, all federal student loans charge simple interest.
However, the way most banks and lenders charge interest is more complicated.
Many lenders charge interest based on an amortization schedule. This includes mortgages and some auto loans. The monthly payment on these types of loans is also fixed — the loan is paid over time in equal installments. However, how the lender charges interest changes over time.
With amortizing loans, the initial payments are generally interest-heavy, meaning less money you pay each month goes toward your principal loan amount.
However, as time passes and you draw closer to your loan payoff date, the table turns. Toward the end of your loan, the lender applies most of your monthly payments to your principal balance and less toward interest fees.
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.
Who benefits from amortized interest
Lenders are the primary beneficiaries of amortized interest. Payments are applied to both principal and interest, extending the length of the loan and increasing the interest paid over time.
Types of loans that use amortized interest
Many loan types installment loans use amortized interest, including auto loans, mortgages and debt consolidation loans. You may also encounter amortized interest on home equity loans.
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 because it means more of a risk for the lender.
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.
Your interest rate is extremely important when figuring out the 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 interest cost 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 months it takes to repay the money you borrow can significantly impact your interest costs.
Shorter loan terms generally require higher monthly payments, but you’ll incur less interest because you minimize 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.
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. However, make sure the payments go to paying down the principal.
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 can 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.
- Opt for a shorter repayment timeline: The best interest rates will always accompany the shortest-term loans. You will pay less interest over time if you can afford the payments.
- 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.
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.