Interest Rates Loans

How To Calculate Interest On a Loan

One of the essential steps in any loan process 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 is overwhelming. Luckily, CreditNinja is here to help you figure out how to calculate interest on your loan.

Interest is just one aspect of a loan or financial product. There are so many things to keep track of when you’re considering a new loan. For instance, you should be familiar with the length of the repayment period, the late fees, the processing and origination fees, and of course, the interest rate.

If you’ve never taken out a large loan before, all of these things can be overwhelming.

So it’s best to do plenty of research and prep beforehand. Learning everything you can about interest rates will help you in the long run. And it will help when you’re talking to the lender and trying to negotiate a good deal.

Read on to learn more about interest rates, interest payments, and the annual percentage rate.

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.

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.

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 than 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 you’re shopping for a loan, whether it’s an auto loan, mortgage, or 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.

Let’s start with simple interest.

Simple Interest

Simple interest is the easiest type of interest rate to calculate and plan for. The formula for calculating the interest you pay with this type of rate 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% X 5 years = $12,500 total interest over the life of the loan.

This interest rate is often found with auto loans, smaller personal loans, and sometimes with mortgages. It’s relatively easy to calculate interest if you have a simple interest rate. 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 to calculate interest when you have a compound interest rate is difficult. But the most crucial thing to know is that its interest on interest. This means that instead of interest only being applied to the principal (the amount borrowed), they 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 will 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 the one thing that you can control is your credit score. Having a good credit score will help you receive better interest rates, no matter which kind of loan you’re applying for.

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 good credit score.

Having a good credit score makes you much more likely to get a reasonable interest rate on your loan.

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:

Payment history (35%)
Amounts owed (30%)
Length of credit history (15%)
Credit mix (10%)
New credit (10%)

This list is what you want to pay attention to as you manage your bills, credit cards, monthly budget, and more. Of course, 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.

If you pay attention to these things and check your credit report and score often, you will start to see your credit score rise. And with a high credit score comes a low interest rate and manageable interest payments.

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 easy. So why not just have a free website calculate the interest for you?

In Conclusion

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

Your interest will either be simple or compound; make sure you know which it is.

Your credit score will affect the type of rate you get for your loan. 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 interest calculator online to double-check everything.

If you remember these things, you can avoid being taken advantage of with your loan. 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.

References:
https://www.investopedia.com/terms/i/interestrate.asp
https://www.investopedia.com/terms/a/apr.asp
https://www.myfico.com/credit-education/whats-in-your-credit-score