how to calculate interest rate on loan

How to Calculate Interest on Your Loan Amount? 

Before we borrow money from a bank, it is crucial to know how they calculate the interest rate on a loan. Banks use different methods to calculate interest rates on loans, and each method changes the amount of Interest you pay. This is why knowing how to calculate Interest is important to understanding your loan contract with your bank. This will help you negotiate interest rates better.

What is the Interest rate on the Loan?

The term interest on a loan refers to the money you have to repay if you borrow. To calculate Interest on a loan, you need to determine the principal loan amount, interest rate, and the loan term up to which you will pay Interest and principal. The interest rate is the amount a lender charges if you borrow money, usually shown as a percentage of the principal amount. This borrowed money can be cash or assets like cars, houses, or everyday items. 

Key Highlights

  1. Lenders use different methods to calculate the interest rate on your Loan. The most common ones are simple Interest or amortised schedules.
  2. Simple Interest is mostly calculated on short-term, personal, and federal student loans; however, some mortgages and auto loans have an amortisation schedule.
  3. Interest rates are directly proportional to the level of risk associated with the borrower. The interest rate can be compensation for the loss caused to the asset due to the use. Interest rates can be applied over different periods, such as monthly, quarterly, or biannually; however, in most cases, interest rates are annualised.

How do banks calculate your Loan interest rate? 

When you take a loan, the lender earns money by charging interest. The method of charging Interest can be simple Interest or an amortisation schedule. However, it is important to understand that besides the type of Interest, the cost of your Loan depends on other things, too.

Simple Interest

When the lender uses a simple interest method, it becomes straightforward if you have the right information. You need your principal loan amount, interest rate, and loan term to calculate the overall interest cost using the simple interest method. 

In the simple interest method, the monthly payment remains the same. Still, the Interest is based on the outstanding principal balance each month. This implies that if you pay off the Loan early, you can save a substantial amount in Interest, as the lender doesn't penalize early payment.

Who gets the most benefits?

  1. Borrowers who make consistent or early payments benefit the most when the lender calculates Interest using the simple interest method. Since Interest is only calculated on the principal amount in this type of method, borrowers save a handful of amounts rather than compound Interest. 

  2. Lenders do not widely use the simple interest method. Therefore, and therefore, it is only available to some short-term loans, like payday or car title loans, or even some personal loans, vehicle loans, and other mortgages. Borrowers with student loans also pay simple Interest, as all federal student loans charge simple Interest.

Amortising Schedule

Many lenders use amortisation schedules to calculate Interest on loans. In the amortisation method, the monthly payment remains the same as in the simple Interest, but the Interest changes over time. The major difference between amortising loans and simple interest loans is their distribution of payments.  

In the initial phase, amortising loans are heavily burdened with interest payments. As time goes on and the borrower gets closer to paying off his Loan, the lender directs the majority of monthly payments towards reducing the principal balance, which eventually reduces the amount going to paying Interest.

Who gets the most benefits?

Lenders mostly favour amortised interest rates as payments are all directed towards both principal amount and Interest. This structure provides a systematic repayment approach that extends the time. To pay off the Loan and increase the total Interest on the borrower. 

It is pretty common for different loan installments, such as auto loans, mortgages, and debt consolidation loans. Many lenders even extend this method to home equity loans.

What is the formula to calculate loan interest? 

Formula to calculate loan interest

1. Simple Interest

Principle loan amount * Interest rate* Loan term = Interest

For example,
If you take out a five-year loan for $30,000 with an interest rate of 5%. By applying the simple interest formula, the Interest comes to $7,500

($30,000* (5/100)*5)= $7,500

2. Amortised Interest 

Calculating amortised Interest can be tricky. 

  1. First, calculate the monthly interest rate by dividing the annual interest rate by the monthly payments you make. 
  2. For example, if your interest rate is 6% and you make monthly payments, then divide 0.06 by 12, you get 0.005
  3. Monthly Interest Rate= Annual Interest Rate/ Number of Payments per year = 0.006/12= 0.005

Find how much monthly Interest you need to pay

1. Multiply the monthly interest rate by the remaining loan balance to find out how much interest rate you will pay that month.  
For example, if the loan balance is $5,000, then the Interest for the first month would be $25
Interest for the Month = Remaining Loan Balance* Monthly Interest Rate= $5,000/ 0.005= $25

2. Calculate the principal payment by subtracting the Interest calculated in the second step from your fixed monthly fee to determine the amount that goes towards the principal for that month.
For example, if your fixed monthly payment is $430.33, you pay $430.33- $ 25 = $405.33 to your principal for the first month.

Principal Payment for the Month = Fixed Monthly Payment- Interest for the Month $30.33-$25= $405.33

3. Update the remaining loan balance by subtracting the principal payment from your remaining loan balance. This new balance becomes the basis for the next month's calculation.
Remaining Loan Balance = Remaining Loan Balance- Principal Payment for the Month.

4. Repeat these steps to update the remaining loan balance for each subsequent month until the Loan is fully repaired.

Factors that can affect how much Interest you pay on your Loan 

Many factors can impact the Interest you pay while taking a loan. Here are some of the various factors that may impact the interest payment on your Loan.

1. Loan amount

The principal loan amount is the money you borrow. It greatly impacts your interest payment as the more money you borrow, the more interest you pay because you increase the lender's risk by taking more money.

2. Credit score

Your credit score determines whether your interest rates will be low or high. If you have less than perfect credit, you increase the risk of the lender as he is granting a loan to a person with less creditworthiness. Therefore, you have a high-interest rate. 

3. Loan term

A loan term is when you agree to pay your Loan to your lender. Mortgages, on average, have a long term of 15 to 30 years. You may opt for a 5-year auto loan, too. However, it is important to understand that the more time it takes to repay the money, the more interest you will pay.

The shorter Loan might have a higher monthly payment, but you incur less Interest because you reduce the repayment time. On the other hand, the longer long-term may reduce the amount for your monthly payment. Still, it extends the repayment time, which eventually increases the Interest you pay.

How do you get the best loan interest rates? 

To get better rates on Interest on your Loan, you must

1. Improve your credit score 

Improving your credit score and getting into the good to excellent range can be beneficial as it helps you get more competitive interest rates than others. Lenders typically look for individuals with credit histories for better interest rates.

2. Go for shorter repayment 

This means that if you have a loan with a shorter repayment tenure, you can have a more favourable interest rate. When you choose a shorter repayment period, you pay higher monthly payments to cover the loan amount, which reduces the life of the Loan, and eventually, you pay less Interest.

3. Decrease your debt-to-income ratio

Your debt-to-income ratio represents how much of your monthly income you put toward debt. Lenders typically look for individuals with a debt-to-income ratio of 36 or less.

4. Compare multiple lenders

The loan rates differ among lenders, and to secure the best rate, it is good to compare offers from different providers. Pre-qualifying with at least three lenders can give you access to the terms and interest rates without negatively impacting your credit score.

Final words

Calculating the interest rate you will pay is always good to better understand the borrowing cost. It is a good idea to ask the lender if Interest is calculated using the simple interest formula or amortisation schedule. It is because both these formulas differentially calculate the Interest you pay, which may impact your borrowing cost. However, it is also important to understand that the loan interest rate method is not the only way to reduce the Interest on your borrowings, as multiple factors determine how much Interest you will pay at the end. Evaluate all the aspects to understand your interest rate better. Work on those to reduce and get a more favourable one.

Read Also:

  1. No Credit Check Loans

  2. How to get a Personal Loan

  3. Home Equity Loans

05 Feb, 2024

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