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How To Calculate Interest on a Loan

By Nooreen B Edited by CreditNinja
Modified on February 20, 2024
how to calculate interest

Calculating interest on a loan will depend on several factors, including the loan amount, credit scores, and whether the loan has a simple, compound, fixed, or variable interest. Borrowers can calculate the interest on a loan via online loan calculators, by reviewing the repayment schedule that came with their loan agreement, or by asking a loan agent. 

One of the most important steps in planning for any loan is knowing and understanding the interest rate. Unfortunately, this can also be a very confusing step if you’re not already familiar with how interest rates work. And we get it; calculating interest for a loan, credit card, or line of credit can seem overwhelming. Luckily, CreditNinja is here to help you figure out how to calculate interest on your loan!

What Is An Interest Rate?

The first step is to figure out precisely what an interest rate is. In the simplest terms, interest is the cost of borrowing. It’s the fee that a lender, credit card company, or other financial institution charges borrowers for the service or product they’re providing. Every loan, financial product, or financial service will come with an interest rate. According to the National Credit Union Association, the average interest rate set by most credit unions in June 2023 was 10.32%, while the average rate for banks was 11.04%.1

The interest rate is how the lender makes money from the loan. And the amount of interest that they charge is the most significant indicator of how much you’ll pay for that loan over time.

It’s important to note that not all interest rates are the same. For instance, the interest rate for a car loan will be very different from a credit card. Therefore, it’s crucial to do plenty of research before applying for your specific loan to know what to expect regarding the interest.

Understanding Interest Rates

It’s also worth mentioning that interest rates on a loan may increase if the borrower misses payments or defaults on their loan. According to The U.S. Department of Health and Human Services, the current value of funds rate as fixed by the Secretary of the Treasury is 11.5%.2

Your interest rate will be expressed as a percentage of the total that you’re borrowing. So, for instance, if you get a $1,000 loan and the interest rate is 10%, you will pay back an extra $100 on top of the $1,000 that you borrowed.

But keep in mind that the interest rate and the annual percentage rate are two different things. And you’ll need to be familiar with both.

The Difference Between Interest Rates and APR

The annual percentage rate is slightly different from the interest rate. This is because the annual percentage rate (APR) is a more all-encompassing percentage that considers all of the fees for a loan.

The APR is the total amount of interest and fees that you’ll pay for the loan annually.

The main difference between the basic interest rate and the APR is that the APR takes additional fees into account.

Most lenders will quote the APR upfront, but it’s essential to make sure that you ask if they don’t. Knowing the APR is more important than just the basic interest rate. The APR allows borrowers to compare and contrast different lenders and loans easily.

A lender that isn’t upfront about the APR or tries to hide it from you is probably not trustworthy. This is one of the red flags you should be aware of when searching for your loan and lender.

Some states have laws that force lenders to disclose the APR specifically. But if yours doesn’t, make sure you find out before signing on the dotted line.

Simple Interest vs. Compound Interest

When shopping around for initial loan approval, whether it’s for auto loans, a mortgage, or a short-term personal loan, you need to know which type of interest rate you’re getting. There are two different interest rates that you’ll encounter: simple interest and compound interest.

Simple Interest

Many consider simple interest as the easiest type of interest rate to calculate and plan for. The formula to calculate simple interest on a loan is as follows: 

  • Principal amount X interest rate X time

Let’s use an example. If you take out a $50,000 loan with a 5% annual interest rate, and your loan term is five years, then the formula is 50,000 X 5% (0.05) X 5 years = $12,500 total interest over the life of the loan.

This interest rate is often found with auto loans, smaller personal installment loans, and sometimes mortgages. It’s relatively easy to calculate interest if you have a simple interest rate. Calculating compound interest, on the other hand, is another story.

Compound Interest

Compound interest is more challenging to calculate, but the most important thing to remember is that you’ll end up paying more.

The process of calculating interest when you have a compound rate is more involved than calculating simple interest. But the most crucial thing to know is its interest. This means that instead of interest only being applied to the principal balance (the amount borrowed), the lender will apply interest to both the principal amount and the previous interest amount that you still owe. This process makes your new interest payments higher.

With a compound interest rate, the interest you pay over the life of the loan may be much more than it would with simple interest. This is the case even if the principal amount is the same.

Interest Rates and Credit Scores

The interest rate that you receive will depend on several different factors:

  • The type of loan and lender you’re using
  • The state of the economy
  • Inflation
  • The borrower’s credit score/history

Most of these things are outside of your control as a borrower. But, having a good credit score will help you receive better interest rates, no matter which kind of loan you’re applying for.

Although there are loans for those with less-than-perfect credit, a lender would typically prefer to offer a loan to a borrower with a demonstrated history of sound financial practices. For example, if you consistently pay your bills on time, don’t have a lot of debt, and manage your credit cards well, you probably have a decent credit score.

However, keep in mind that a good credit history isn’t the only thing that affects your interest rate. For example, if interest rates are high due to the economy or inflation, your credit score will only do so much. But it’s still essential to maintain your credit score to get the best interest rate and lowest interest payments possible.

How To Get Better Interest Rates

The best way to get a better interest rate, as mentioned above, is to improve your credit score. And your first step in this process is to know how to boost that score. The credit bureaus that track your credit history will base your score on a few different factors, all carrying a different weight of importance, including:

  1. Payment history (35%)
  2. Amounts owed (30%)
  3. Length of credit history (15%)
  4. Credit mix (10%)
  5. New credit (10%)

The most crucial factor is your payment history, which means that paying your bills on time is of the utmost importance. It’s the most critical part of your credit score and, therefore, should always be the main focus.

How To Calculate the Interest You Pay

The good news is that many lenders will disclose the interest rate and the total amount of interest you’ll pay for your loan. Furthermore, many lenders are required by law to disclose this information. So the only thing you’ll need to do is to make sure the interest is calculated correctly.

This will require you to read the loan contract, assess the interest rate, and do the math yourself to verify that your lender is calculating interest correctly.

Luckily, finding an interest calculator is as simple as a quick online search. Many websites offer a free online interest calculator for both simple interest and compound interest. These tools are a great way to make sure that the interest is calculated correctly. After all, calculating interest is not always easy. So why not just have a free website calculate the interest for you?

What Details are Included In a Loan Agreement?

Loan DetailDescriptionLoan Type 
Loan AmountThe total amount of money that is borrowed. This is the principal amount on which interest is calculated. All types of loans. 
Repayment ScheduleThe timeline and frequency at which the borrower is expected to make payments towards the loan. This could be monthly, bi-weekly, etc. All types of loans. 
Loan TermThe length of time over which the loan is to be repaid. The loan term may range from a few months (short-term loans) to several years (like mortgages).All types of loans. 
Amortization ScheduleA complete table of periodic loan payments, showing the amount of principal and the amount of interest that comprise each payment until the loan is paid off at the end of the loan term. Mortgages, auto loans, personal loans, etc.  
Monthly Loan paymentThe amount of money that the borrower is expected to pay each month. The monthly payment typically includes a portion of the loan principal and the interest. All types of loans. 
Interest RateThe percentage of the loan amount that is charged as interest to the borrower, typically expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. All types of loans. 
APR (Annual Percentage Rate)The annual rate charged for borrowing earned through an investment, expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. All types of loans. 
FeesAdditional costs associated with the loan, such as origination fees, late fees, prepayment penalties, etc. All types of loans. 
CollateralAn asset that a borrower offers as a way for a lender to secure the loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses. Secured loans like mortgages, auto loans, etc. 
Credit Requirement The minimum credit rating a borrower must have to qualify for the loan. The higher the score, the better the terms of the loan. All types of loans. 

Bottom Line About Calculating Loan Interest

The main points to remember when it comes to interest rates for your loan are:

  • Your interest will either be simple or compound; make sure you know which it is.
  • Your credit score and financial factors, such as your debt-to-income ratio, may affect the type of rate you get for your loan. Usually, a better score = a better interest rate.
  • Make sure to ask the lender a lot of questions and double-check that their math is correct.
  • Use a free online calculator to calculate loan interest rates and double-check everything.

Interest on loans can be a complicated and confusing thing. There’s no shame in not knowing everything about interest. Just make sure that you compensate for that by doing your research and being prepared before applying for that loan.

Interest Rates and Personal Loans FAQ

Who sets the interest rate on loans?

Ultimately, the lender or financial institution (such as banks, credit unions, or direct lenders) will determine the interest rate on personal loans.

What is a loan calculator?

A personal loan calculator is an online tool designed to help borrowers anticipate what their estimated monthly payment will look like when taking their specific loan terms, interest rates, and loan amount into consideration. Borrowers can also use a loan calculator to calculate credit card APRs and interest rates.

What is the difference between fixed and variable interest rates?

Fixed interest refers to rates that stay consistent throughout the life of the loan, resulting in a fixed monthly payment. Variable interest, on the other hand, refers to rates that are subject to change depending on market conditions. This means the monthly payment may be higher or lower in some months.

What are the tax implications of borrowing money?

Depending on the type of loan, the interest you pay might be tax-deductible. For instance, interest paid on mortgages and student loans can often be deducted from your taxable income. However, it’s best to consult with a tax advisor to understand the specific tax implications for your situation.

Who created the system of interest rates?

The concept of charging interest on loans dates back to ancient civilizations. However, the modern system of interest rates is largely shaped by central banks, like the Federal Reserve in the U.S., which set benchmark interest rates to guide the economy. Individual lenders then set their own rates based on these benchmarks and the borrower’s creditworthiness.

How is the total amount paid for a loan calculated?

The total amount paid for a loan is the sum of the original loan amount (principal), the total interest paid over the life of the loan, and any fees associated with the loan. You can calculate this by adding up all your monthly payments over the loan term.

What is the interest rate on bad credit loans?

Traditionally, interest rates on bad credit loans may be higher than other types of funding. These higher rates are due to the risk the lender is taking by extending credit to borrowers with a potentially unstable credit history.

How does the remaining loan balance affect how much interest I pay?

The remaining loan balance is the amount of the loan that you still owe. The higher your remaining balance, the more interest you’ll pay, especially if your loan compounds interest. As you pay down your loan, the interest portion of your monthly payment decreases, and the principal portion increases.

How does a monthly payment affect the total interest paid on a loan?

Your monthly payment includes both principal and interest. If you make larger monthly payments, you’ll pay down the principal faster, which reduces the amount of interest you’ll pay over the life of the loan. Conversely, making a smaller monthly payment might result in you paying more interest over time.

How does the initial loan amount affect how much interest I pay?

The initial loan amount, or principal, is the basis for calculating interest. A larger loan amount typically results in more interest being paid over the life of the loan, assuming the same interest rate and loan term.

What should I consider when deciding to borrow money?

Before you officially decide to borrow money, consider your ability to make the monthly payments, the total cost of the loan, including interest and fees, and how the loan fits into your overall financial plan. Remember, borrowing more than you need can lead to unnecessary interest costs.

A Word From CreditNinja

CreditNinja knows that interest rates can be confusing, especially when you are new to getting loans and handling your own finances. That’s why we offer several free financial calculators to help borrowers calculate their monthly payments and plan for their loans.
As always, CreditNinja encourages borrowers to research their options and shop around before committing to any one loan type or lender! 

References:

  1. Credit Union and Bank Rates 2023 Q2 | NCUA
  2. Interest Rates on Overdue and Delinquent Debts | HHS.gov
  3. https://www.investopedia.com/terms/i/interestrate.asp
  4. https://www.investopedia.com/terms/a/apr.asp
  5. https://www.myfico.com/credit-education/whats-in-your-credit-score
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