How To Calculate Loan Interest: Something Every Borrower Needs To Know (2024)

Types of Interest

Before you begin to calculate a loan’s interest, you must first learn which type of loan it is and how it charges interest. There are two major types of loans: those that use simple interest and those that use amortizing interest.

Simple Interest

As the name implies, simple interest is the easiest to understand and calculate. A loan with simple interest merely applies a fixed interest payment to a fixed loan amount every month for the life of the loan. Calculating the interest is just a matter of multiplying the principal by the interest rate by the duration of the loan.

Loans with simple interest have the same payment each month. This means the amount of interest paid doesn’t change each month. Each payment has the same amount of interest and principal as the others. As a result, your payments will be higher than a loan with amortizing interest, but the total amount of interest paid will be lower.

• Who does simple interest benefit? Loans with simple interest are best for those who want to minimize their interest costs at the expense of having a larger payment. It also means that you have a clearer picture of your borrowing costs, as you don’t have to calculate an amortization schedule. As you’ll see, it’s much easier to calculate simple interest than it is to create an amortization schedule.
• What types of loans use simple interest rates? Common loans with simple interest include vehicle loans and short-term personal loans. However, these loans don’t necessarily all use simple interest, and you should carefully check the terms of the loan to determine which kind of loan it is.

Amortizing Interest

Loans with amortizing interest charge a different ratio of interest to principal each month. At the start of the loan, only a small part of each payment goes toward paying down the principal, and the largest part goes to interest. But as the loan is paid off, interest is only being charged on the remaining amount of principal. Toward the end of the loan’s term, most of the payment goes to the principal and a decreasing amount goes to interest. However, your payment amount will remain the same each month—only the ratio of principal to interest will change.

Loans can amortize daily or weekly, but the most common terms have monthly payments. Loans with amortizing interest will have lower monthly payments, but higher total interest costs. Some amortizing loans allow you to pay them off early, while others have prepayment penalties. Borrowers should be careful to determine if their loan has a prepayment penalty, as this can make it costly to refinance the loan or even pay it off.

• Who does amortized interest benefit? A loan with amortizing interest will benefit those who are borrowing the most. You will also benefit from amortizing interest when you have a longer-term loan. That’s why loans with amortized interest are almost always used for mortgages.
• What types of loans use amortized interest rates? There are several types of loans that use amortized interest rates, including home mortgages, home equity loans, business loans and some car loans.

How To Calculate Simple Interest on a Loan

Required Items:

• The loan’s principal, which is the amount you borrowed
• The loan’s interest rate
• The length of the loan
• The terms of your loan, specifically if it’s simple interest or amortized interest
• A calculator, or calculating program or app

1. Convert the Interest Rate From a Percentage

Interest rates are typically expressed as a percentage, but to calculate interest, it helps to convert it to a standard number. To do this, divide the percentage by 100. If the interest rate is 8% and you divide 8 by 100, you get 0.08.

2. Multiply the Loan’s Principal Amount by the Interest Rate

Start with the amount being borrowed, also called the loan’s principal. Then, multiply the principal by the loan’s interest rate. If you’re calculating the interest on a $10,000 loan borrowed at 8 percent, multiply 10,000 by the previously calculated figure, 0.08. The result is $800. This represents the annual interest charges on your $10,000 loan.

3. Multiply the Annual Interest Charges by the Loan’s Length

To find the total interest charged over the life of the loan, multiply the annual interest charges by the number of years in the loan. If it’s a 10-year loan, you would multiply the $800 in annual interest by five to get $8,000. That is the total amount of interest incurred during the life of the loan.

How To Calculate Amortizing Interest on a Loan

1. Convert the Interest Rate From a Percentage

Just as you would when calculating simple interest, you need to first convert the interest rate from a percentage. So, divide the percentage by 100. If the interest rate is 8% and you divide 8 by 100, the result is 0.08.

2. Divide the Interest Rate by the Number of Payments That Are Due Each Year

If you make a single payment each month, divide your interest rate by 12. In this example, you’ll divide 0.08 by 12 to get 0.0067. This is your monthly interest rate.

3. Multiply Your Monthly Interest Rate by Your Remaining Balance

A $10,000 loan multiplied by your monthly interest rate of 0.0067 results in an interest charge of $66.67 for that month.

4. Calculate the Principal Paid That Month

To calculate how much in principal you will pay in the first month, subtract the interest for the month from your fixed monthly payment. With the example of a $10,000 loan with a 10-year term at 8% interest, the monthly payment is $121. When you subtract $66.67 from $121, you get $54.33 in principal paid. This reduces the principal of the $10,000 loan to $9,945.67

5. Repeat the Process for Each Month

With a loan that has amortizing interest, the amount of interest paid decreases each month as the principal amount decreases. The amount of the payment stays the same, but a larger percentage of it goes toward paying down the principal each month until the loan is paid off. Since it would take a very long time to manually calculate the interest paid every month, you may wish to use an online mortgage calculator to produce an amortization schedule. This is a list of the interest and principal paid each month throughout the lifetime of the loan. In fact, many mortgages and other loans include an amortization schedule in their closing documents

What Affects My Loan Interest Rate?

The Market Conditions

One of the largest factors affecting your loan’s interest rate is the overall market conditions, which are outside of a borrower’s control. For example, the Federal Open Market Committee (FOMC) sets the prime rate, which directly affects many loans, including credit card interest rates. The bond market also affects loan rates, especially mortgage rates.

Your Credit History and Credit Score

Along with the overall market conditions, a borrower’s credit history is a major factor in the interest rate received. Those with a strong credit history have a higher credit score and are offered the most competitive interest rates. Those who have shorter credit histories—and those who have trouble making payments—tend to have lower credit scores and qualify for higher rates.

Secured vs. Unsecured Loans

Secured loans, including home mortgages and vehicle loans, tend to have lower interest rates than unsecured loans. Lenders can offer lower rates on these loans because the risk of loss is lower. If the borrower defaults, for example, they can foreclose on the home or repossess the vehicle.

Types of Loans

Different types of loans will have different interest rates. A student loan may have a lower rate than a personal loan, as students funding their education are seen as having a lower risk of default. Cash advances and payday loans are seen as having a high risk of default and have higher interest rates.

Loan Terms

Loans with a shorter term have lower interest rates. For example, you can expect a lower interest rate on a 15-year mortgage compared to a 30-year mortgage. Similarly, a three-year car loan typically has a lower rate than a six-year loan.