Borrowing money is often an expensive transaction, and not only because you have to repay your loan amount. What really determines the cost of borrowing is the interest you’ll pay throughout the life of your loan. This amount is money you pay for the privilege of borrowing, and it’s money your lender keeps in order to remain profitable and service your loan.
While loan calculators can help you figure out how much interest you’ll pay each month and throughout the life of your loan, understanding how interest on a loan is calculated can still be helpful, as well as reduce the mystery of loan costs. You should also understand the different types of loans available and how interest calculations work differently with each one.
This guide breaks down some basic calculations you can use when calculating loan payments and figuring out how much interest you’ll pay over the long haul.
The first detail you should know and understand is the type of loan you have. With interest-only loans, for example, you’ll only pay the interest on the loan for a specified length of time, and the amount of principal you owe (the amount you borrowed) will stay the same during that period. With this type of loan, figuring out your monthly payment and loan costs is a breeze, and you may not even need any tools to calculate loan payments or long-term interest costs.
For example, let’s say you took out a loan for $20,000 with an annual percentage rate (APR) of 6 percent and a repayment term of 10 years. In that case, you would take the amount you borrowed and multiply it by your interest rate. This figure would represent your annual interest costs, which you would divide by 12 months.
$20,000 x .06 = $1,200 in interest each year
$1,200 divided by 12 months = $100 in interest per month
Of course, interest-only loans don’t last forever. Once the interest-only portion of your loan ends, you’ll be required to repay the principal amount you borrowed. Typically, interest-only loans turn into amortizing loans that require you to make regular monthly payments on principal and interest after the interest-only period ends.
Now, let’s imagine you applied for an amortizing loan, which is a type of loan that applies some of your payment toward your principal balance as well as interest each month. Since payments are applied to your balance, the amount you owe is slowly reduced over time. As a result, your interest charges will also go down every month until your loan is paid off.
A good example of an amortizing loan is a five-year car loan with a monthly payment and a set repayment date. The example we used above will also work to show how a loan calculation works without a loan calculator.
Let’s say you took out a personal loan for $20,000 with an APR of 6 percent and a five-year repayment timeline. Here’s how you would calculate loan interest payments.
- Divide the interest rate you’re being charged by the number of payments you’ll make each year, which should be 12.
- Multiply that figure by the initial balance of your loan, which should start at the full amount you borrowed.
Using the example above, your math so far would work like this:
.06 divided by 12 = .005
.005 x $20,000 = $100
This loan calculation will provide you with your first month’s interest payment, which happens to be $100. Keep in mind, however, that you’ll owe a smaller amount toward interest each month as your loan balance is paid off.
From that point forward, you can figure out each month’s interest payment by doing the same math cited above using your new, lower loan balance.
The amount of money you pay toward your loan’s principal and interest each month will also be determined by your principal balance and repayment timeline. Note that you can easily figure out the breakdown of your monthly payment on a loan (including principal and interest) using Bankrate’s loan calculator.
As you figure out how your loan breaks down, it can also help to put the information into a table. As you’ll see below, amortizing loans slowly ratchet up the amount you pay toward principal each month while slowly lowering how much interest you pay.
|Starting loan balance||Monthly payment||Paid toward principal||Paid toward interest||New loan balance|
How to save money on loan interest payments
While borrowing money is rarely ever free, you do have some control over how much interest you pay over time. Here are a few strategies to consider that might help you save money on your loan over time:
1. Shop around and compare loan rates
Spend some time comparing loan offers and interest rates to make sure you wind up with the least expensive loan you can qualify for. You can use a loan calculator to figure out the total interest costs for each loan you’re considering. Also keep in mind that it’s possible to get prequalified for a personal loan without impacting your credit score.
2. Consider a 0% APR credit card
If you need to make a large purchase and pay it off over time, you might also look into 0 percent APR credit cards. Many cards in this category let you avoid interest payments on purchases for up to 18 months. Just keep in mind that once your introductory offer is over, your rate will reset to a much higher variable interest rate.
3. Make extra payments toward your loan principal
The examples in the table above may clue you into another easy way to save money on loan interest. By making extra payments toward your loan principal, you can reduce your loan balance and the amount of interest you pay each month. Note that, because more interest is charged upfront on amortizing loans, you’ll make a bigger impact if you make extra principal payments at the beginning. Just make sure your loan doesn’t charge any prepayment penalties, which it shouldn’t.