How to Calculate Interest on a Loan

Calculating interest on a loan: Simple interest

If a lender uses the simple interest method, calculating loan interest becomes straightforward provided you have the necessary details. Essential information includes the principal loan amount, the interest rate, and the loan term, which collectively enable the determination of overall interest expenses.

Note that monthly payment is fixed, but you will have to pay an interest every month based on the outstanding principal balance. Hence, paying the loan early enables you to pay off your loan early, which means that you could save a sizable amount in interest, assuming the lender doesn’t charge a prepayment penalty.

How to calculate simple interest

To calculate your total interest, you can use 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.

If you are not a fan of working off numbers, you can opt for a simple interest calculator to help you with the numbers. With this calculator you can always make those fine errors.

Who benefits from simple interest

The major beneficiaries of the simple interest process are the borrowers who make on-time or early payments. This is so because this process is calculated based on the loan principal, hence, borrowers can save with these loans as compared to those using the compound interest.

Types of loans that use simple interest

The simple interest is obviously not common which means that you might encounter this form of interest on short-term loans, lieke the payday loans and car title loans, as well as some personal loans, vehicle loans and mortgages.

Simple interest is also paid by those with student loans. For instance, all federal student loans charge simple interest.

Calculating interest on a loan: Amortising interest

The amortization schedule is a system that has been used by Many lenders. This includes mortgages and some auto loans. This system also has a fixed monthly payment on— the loan is paid over time in equal instalments. However, how the lender charges interest changes over time.

Difference Between Amortizing loans and Simple Interest Loans,

The major difference is that with amortising loans, the initial payments are generally interest-heavy. This means that a less significant portion of your monthly income goes to your principal loan amount.

However, with time as you get on with 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 rather than your interest fees.

How to calculate amortised interest loan

Here’s how to calculate the interest on an amortised loan:

Divide your interest rate by your yearly payment. That is, if you have a 6 percent interest rate and you make monthly payments, you would divide 0.06 by 12 to get 0.005.

To know how much you’ll pay in that month, multiply that number by your remaining loan balance. This means, if you have a $5,000 loan balance, your first month of interest would be $25.

To know how much in principal you are to pay, subtract that interest from your fixed monthly payment. Hence, 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.

Example of amortization schedule for a $5,000, one-year personal loan with a 12.10 percent interest rate, which is the average interest rate on personal loans as of March 2024.

Payment Date Payment Principal Interest Total Interest Balance
Oct 2023 $442.65 $395.49 $47.17 $47.17 $4,604.51
Nov 2023 $442.65 $399.22 $43.44 $90.60 $4,205.29
Dec 2023 $442.65 $402.99 $39.67 $130.27 $3,802.31
Jan 2024 $442.65 $406.79 $35.87 $166.14 $3,395.52
Feb 2024 $442.65 $410.62 $32.03 $198.17 $2,984.90
Mar 2024 $442.65 $414.50 $28.16 $226.33 $2,570.40
Apr 2024 $442.65 $418.41 $24.25 $250.58 $2,151.99
May 2024 $442.65 $422.35 $20.30 $270.88 $1,729.64
Jun 2024 $442.65 $426.34 $16.32 $287.19 $1,303.30
Jul 2024 $442.65 $430.36 $12.29 $299.49 $872.94
Aug 2024 $442.65 $434.42 $8.23 $307.72 $438.52
Sep 2024 $442.65 $438.52 $4.14 $311.86 $0.00

 

Who benefits from amortized interest

The primary beneficiaries are the lenders.

Types of loans that use amortized interest

Many types of installment loans make use of the amortized interest like auto loans, mortgages and debt consolidation loans.There is also an amortized interest on home equity loans.

Factors that can affect how much interest you pay

Loan amount

Your credit score

Loan term

Repayment schedule

Repayment amount

CONCLUSION:

To bring this home, before thinking of getting a loan it’s important to calculate how much you’ll pay in interest to understand the true borrowing costs. Always try to communicate with the lender to know if the interest is assessed using the simple interest formula or an amortization schedule. After this process, you can always use the appropriate formula or an online calculator to run the numbers.

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