How to calculate interest on a loan

Whenever you borrow a loan, the lender charges interest on the loan, which represents the cost of borrowing the loan.

Knowing how loan interest is calculated can help you better understand your repayment obligations. When you repay the loan, you not only pay off the principal but also repay the interest.

Here’s what you should learn about how to calculate the interest rate on loans:

A common question that plagues borrowers is how to work out interest on a loan. Usually, the interest on any type of loan is determined based on the daily unpaid balance of the amount borrowed.

Remember that the approach adopted by lenders for calculating interest on loans varies. Some opt for the simple interest method, while others use an amortisation schedule. Lenders may also follow a different approach to calculate the interest for high-risk loans such as payday loans. Similarly, in the case of consistent loan default on an existing borrowing, lenders may revisit the interest rate.

Here’s how interest rate is calculated for simple and amortising loans:

Simple loan

If you want to calculate interest payment using the simple interest method, you need to know the principal amount borrowed, the interest rate charged, and the number of months or years you have to repay the loan.

Use the following formula to calculate interest on a loan:

For instance, if you borrow $5,000 for five years and the interest rate is 5 percent, as per the simple interest formula, you need to pay $1250 as interest.

However, calculating interest on a loan using the simple interest method is only restricted to short-term borrowings.

Amortised loan

The interest for bigger loans, such as a refinance mortgage, is worked out based on an amortisation schedule.

The monthly instalment is fixed at the time of disbursal, and the loan is repaid in equal instalments.

The initial instalments are used towards paying off the interest. As you get closer to repaying the final payoff date, the instalments are applied towards paying off the principal and other fees and costs.

Here’s how to calculate interest on a loan that is amortised:

• The applicable interest rate of the loan should be divided by the number of payments you need to make in a year. For instance, if the loan carries 7 percent interest and you need to pay an instalment every month, you must divide 0.07 by 12.

• The result (which is 0.005 in this case) should be multiplied by the loan balance. This will tell you how much interest you need to pay during a particular month. Suppose you have a mortgage, and the outstanding is $6,000 -- so how to calculate mortgage interest for the first month. In this case, it is $6,000 x 0.005, which is $30.

• The next step of interest on loan calculation involves subtracting the interest from the monthly instalment amount. This tells you how much you need to pay towards the principal. For example, if the monthly instalment has been fixed at $400, you will pay $370 towards the principal, which gets deducted from the outstanding amount.

• For each subsequent month, you need to change the new loan balance for the preceding month in the monthly repayment formula to work out the amortised interest.

As the above example shows, calculating the amortisation schedule requires a lot of maths. Wondering how to calculate principal and interest payments for an amortised loan easily? You can use an online calculator that does the job for you. All you need to do is feed in the data.

Calculation of interest on an amortised loan can also be done through Microsoft Excel or Google Sheets, as they have in-built calculators.

To calculate interest on a loan, multiply the loan balance by the interest rate specified by the lender. When you divide the result by the number of days of the year, you get the daily interest.

For example, if you have borrowed $200,000 at 2.52 percent per annum. The daily interest will be $ 200,000 x 0.0252/365, which is $12.808

And how to calculate monthly interest on a loan? Multiply the daily interest by the number of days of the month.

Therefore, for January, it will be $12.808 x 31, which is $ 397.

Interest rate

The interest rate plays a critical role in calculating the total cost of borrowing any loan.

The total interest paid for the loan will be higher if the interest rate is higher.

Also, consider whether the interest rate offered by the lenders is variable or fixed. The total interest cost can fluctuate through the life of your loan if the interest rate is variable.

Loan amount

The amount you borrow has a significant impact on loan interest calculations. The more you borrow, the more it costs.

For example, suppose you borrow an amortised personal loan of $10,000 for five years at an interest rate of 5 percent. In this case, you will pay $1,322.74 as interest.

However, if you borrow $15,000 for the same term and interest rate, the total interest increases to $1,984.11.

As a rule of thumb, refrain from borrowing more than you need, as it can translate into higher interest payments.

Loan term

Loan term refers to the period within which you need to repay a loan. The longer the loan term, the more interest you need to pay.

Shorter loans, such as car loans, have higher monthly instalments. But you pay lesser interest overall since the timeline is constricted. However, home loans (that are typically for 15 or 30 years) require you to pay higher interest over time since the timeframe for repayment is considerably longer.

In other words, the interest paid varies depending on how long you take to repay the loan.

Here’s what you can do to maximise your chances of borrowing a loan at an attractive interest rate:

Work on your credit score

Your credit score indicates your creditworthiness.

Borrowers with the highest credit score have a better chance of securing the most competitive interest rates for loans. On the contrary, bad credit scores can push you to borrow specialised loans such as home loans for bad credit that carry a very high-interest rate compared to standard mortgage loans.

To improve your credit score, pay your loan instalments on time and avoid unnecessarily applying for additional credit.

If you don’t know your current score, you can check credit score for free with ClearScore, anytime.

Opt for a shorter repayment timeline

Opting for a shorter-term loan is a great way to get the best interest rate from the lenders.

However, you should exercise the option only if you can afford the repayments. Missing instalments can negatively impact your credit score, forcing you to reach out to specialised lenders for future borrowings.

However, products such as a personal loan for bad credit carry a higher interest rate as your creditworthiness declines because of a poor credit score.

Pay attention to your debt-to-income ratio

When lenders evaluate your loan application, your debt-to-income (DTI) ratio is critical in determining the interest rate offered.

DTI is the ratio of the debt you have to your gross monthly income. The lower your DTI, the better your chances of getting a low-interest loan.

Even though credit cards are a type of financial assistance, interest rate calculation for credit cards is not the same as for loans.

The interest rate for a credit card is calculated daily based on the outstanding balance. It includes purchases that don’t enjoy any interest-free period, balance transfers, cash withdrawals from ATMs, interest carried over from previous months, and other fees levied by the issuer.

Typically, lenders charge different interest rates for purchases, balance transfers, and cash withdrawals.

The amount of credit card interest paid every month depends on several factors, such as:

How much you repay

If you only pay the minimum amount due on your card instead of paying the dues in full, you do not enjoy the interest-free period of your card. In such cases, the total interest paid quickly adds up over time.

Type of credit card you hold

The interest rate of credit cards that permit their holders to earn reward points is higher. Cards that do not offer such perks charge lower interest.

The number of days in the month

Since the interest is calculated on a daily basis, more days in a month means higher interest paid.

The best way to reduce credit card interest paid is by paying the outstanding dues in full by the due date. If you find managing interest payments on your credit cards difficult, consider opting for a low-interest-rate card. Alternatively, you can borrow debt consolidation loan s to clear your dues.

‘How much interest will I pay on my loan’ is a crucial consideration for any borrower. It can be easier to decide once you know how to calculate interest rate per month for the loan you plan to borrow.