How to calculate loan interest

How to calculate interest on a loan

Lenders use various methods to calculate interest — some of which are much more complicated than others. However, most lenders use the simple interest method.

Simple interest calculator

To calculate simple interest on a loan, multiply the principal (P) by the interest rate (R) by the loan term in years (T), then divide the total by 100. To use this formula, make sure you’re expressing your interest rate as a percentage, not a decimal (i.e., a rate of 4% would go into the formula as 4, not 0.04).

Amortization calculator

Not all loans use the simple interest formula. Mortgages are amortized loans, meaning the monthly payment on these loans is fixed. Your amortization schedule shows how much of each payment goes to interest and how much goes to the principal. The simplest way to calculate your amortization loan is the following:

Amortization interest formula: Remaining loan balance x (annual interest rate divided by 12) =interest due for that month

Principal payment = monthly payment - interest due for the period

With an amortization loan, your principal changes monthly, so your unique calculation changes constantly too.

• Figure out your monthly interest due by dividing your interest rate by 12. For example, an 8% interest rate loan would be .007 (.08 divided by 12).
• If your mortgage is $400,000 with an 8% interest rate, then your first interest charge would be $2,666.67. If your monthly payment is $2,935, then $268.33 of your payment would go toward principal.
• The following month, you would calculate interest using your new loan principal of $399,6731.67.

What is loan interest?

When you take out a loan, you have to pay back both the principal and the interest, which is one of the main ways lenders make a profit. You can think of interest as the amount of money the lender charges for access to the loan funds.

The interest rate is expressed as an annual percentage of the total loan amount. Each of your monthly payments goes towards a portion of the principal and interest (the ratios will change throughout the course of an amortized loan).

Simple interest

Simple interest is the easy way to calculate the interest charge. You use the simple interest formula to determine how much interest you will pay on a loan that does not compound. Calculating simple interest will help you discover how much money you can save by paying more toward your loan monthly.

Amortizing loans

Many loans, including mortgages, auto loans and student loans, are amortized, meaning each of your monthly payments includes a percentage of the total outstanding principal and interest on the loan.

In the first months of your loan repayment, your payments are interest-heavy. As time passes, the amount of your monthly payment that goes toward interest decreases, and the amount of your monthly payment that goes toward principal increases.

It can help to use a loan calculator to better understand how your interest rate affects your monthly payment and the total amount of interest you'll pay over the life of the loan.

Loan interest vs. annual percentage rate

Usually, the rate a lender quotes is actually the annual percentage rate (APR), which is a combination of interest, fees (like an origination fee) and other costs. Your APR is an annual percentage of your loan principal (the total amount you take out) that you pay each year to borrow that money.

Functionally, your APR might be the only number you care about, so be aware that there is a difference between it and your actual interest rate. To calculate how much you'll pay using the APR, you can use the same formula but substitute your APR for the interest rate.

» MORE: Best personal loans with a co-signer

How are interest rates determined?

Each lender sets interest rates based on market conditions, competitors' rates and the borrower’s financial situation. The reason lenders look closely at your credit history, credit score, income and debts is to determine how much of a risk you pose as a borrower.

Borrowers with bad credit may be more likely to default on the loan, so lenders do what they can to make sure they are financially protected. A higher interest rate makes a risky loan safer for the lender’s bottom line.

Interest rates also depend on whether a loan is secured or unsecured. For example, an auto loan is a secured loan that uses the car as collateral. That means the lender can legally repossess the vehicle and sell it if you default on the loan. An unsecured loan, on the other hand, doesn't require collateral. Since unsecured loans are riskier for lenders, they usually have higher interest rates. In either case, borrowers with excellent credit tend to get the lowest rates.

How to get the best interest rates

A lower interest rate can mean big savings as you repay a loan. Here are some tips to get a great interest rate on a loan.

1. Improve your credit score.

Working to improve your credit score may help you secure a loan with a lower interest rate, especially if your credit score is in the mid-600s or lower. Fixing your credit takes time, so if you urgently need a personal loan to cover unexpected expenses or to pay for an emergency, you may not be able to do much to boost your score instantly.

2. Check your credit report for mistakes.

You can see each of your credit reports from Experian, Equifax and TransUnion at least once every 12 months for free. Look through the reports for accounts you don't recognize or misreported late payments. If you find mistakes, let the credit bureau know you'd like to dispute the information.

It may take up to a month for the bureau to investigate and resolve your dispute. Credit repair companies can take care of this for you if you don’t have the time or energy to do it yourself.

If your credit report includes past-due bills, work to get those resolved. You may be able to negotiate with the creditor to settle the debt so you pay less than the total amount due and get the remainder of the debt canceled. If you work out a deal like this, be sure to get it in writing before you send the payment. Also, never give a collection agency access to your bank account.

3. Make your loan and credit card payments on time.

Even one late payment can damage your credit score. If you have revolving credit accounts, pay down your balances to decrease your credit utilization ratio. A good credit utilization ratio (your total balances divided by the total amount of available credit across all your revolving accounts) is 30% or lower. Another way to improve your credit utilization ratio is to ask for a credit limit increase.

4. Shop around for the best loan terms.

With average to good credit, you can choose from a number of lenders. Don't take the first offer you receive, though. Check with your bank or credit union to find out if it offers the type of credit you need; many smaller financial institutions have unadvertised low-interest loans or lines of credit reserved for their existing customers.

You can also use a loan comparison tool like this one to compare loan options side by side. After answering questions about your specific situation and needs, you'll see offers from lenders that may work with you. You can review all of the options at once before selecting the one that's best for you.

5. Sign up for automatic payments.

Your lender may provide an interest rate discount if you agree to make automatic payments from your bank account. This also helps prevent harm to your credit score if you get busy and forget to make a payment.

6. Choose a shorter loan term.

“Typically a shorter term personal loan will get you a better rate,” said Derek Sall, founder and lead of Life And My Finances. “This is mainly because with the shorter term loan, you're less of a risk to the bank. You'll pay off your debt faster, and they'll be able to turn that money quickly into yet another investment and make more money on it.”

If you can afford larger monthly payments, choose a loan with a shorter repayment schedule to save money on interest.

7. Improve your debt-to-income ratio.

Your debt-to-income (DTI) ratio is your total monthly debt payments divided by your total gross monthly income. Lenders use this formula to determine whether you can make the monthly payments on your loan. Lenders like to see a DTI ratio of 36% or less in general, although many will approve an applicant with a higher ratio.

8. Consider adding a co-signer with a higher credit score.

If your credit score is too low to qualify for a loan with a low interest rate, adding a co-signer with good credit could help you get a better one. Keep in mind that the co-signer is just as responsible for the debt as you if they sign on, though, so be sure to make your payments to avoid them having to assume the debt for you.

» MORE: What is a good credit score?

Bottom line

When you borrow money, it's important to pay close attention to your interest rate and how your lender calculates your monthly payments. Before you accept the funds, use an online calculator to add up exactly how much interest you'll pay over the life of the loan. Consider reducing the term of the loan to see if you can afford a slightly larger monthly payment in exchange for paying less interest over time.

Borrowing money costs money, so proceed with caution when you take out a loan. Paying off your balance faster could save you money if you’re not subject to prepayment penalties.