When you borrow money, the lender will ask you to repay those funds over time. But banks expect to be paid something in exchange for their services and the risk they take when lending you money. That means you won’t just pay back the money you borrowed. You’ll pay back the loan plus an additional sum, known as interest.
Interest is one of the primary ways that lenders, banks and credit card issuers earn a profit. Here’s a look at how interest works and how you can calculate the cost when you borrow money.
What is interest?
Interest is the price you pay to borrow money from someone else. If you borrow a $20,000 personal loan, you may wind up paying the lender a total of almost $23,000 over the next five years. That extra $3,000 is interest.
As you repay your loan over time, a portion of each payment goes toward the amount you borrowed (the principal) and another portion goes toward interest costs. The interest you’re charged is determined by things like your credit history, income, loan amount, loan terms and current amount of debt.
How to calculate interest on a loan
Lenders take different approaches when it comes to the interest they charge. This can make calculating loan interest difficult, since some types of interest require a bit more math.
If a lender uses the simple interest method, it’s easy to calculate the interest on your loan if you have the right information available.
- Gather information like your principal loan amount, interest rate and total number of months or years that you’ll be paying the loan.
- Calculate your total interest by using this formula: Principal Loan Amount x Interest Rate x Time (aka Number of Years in Term) = Interest.
If you take out a five-year loan for $20,000 and the interest rate on the loan is 5 percent, the simple interest formula works as follows:
$20,000 x .05 x 5 = $5,000 in interest
You might encounter simple interest on short-term loans. However, the way most banks and lenders charge interest is more complicated.
Many lenders charge interest based on an amortization schedule. Student loans, mortgages and auto loans often fit into this category. The monthly payment on these types of loans remains fixed and the loan is paid over time in equal installments, but the way the lender applies the payments you’re making to the loan balance changes over time.
With amortizing loans, the initial payments are generally interest-heavy, meaning less of the money you are paying each month goes toward paying your principal loan amount.
As time passes and you draw closer to your loan payoff date, however, the table turns. Toward the end of your loan, the lender applies the majority of your monthly payments to your principal balance and less toward interest fees. Here’s how to calculate that:
- Divide your interest rate by the number of payments you’ll make that year. If you have a 6 percent interest rate and you make monthly payments, you would divide 0.06 by 12 to get 0.005.
- Multiply that number by your remaining loan balance to find out how much you’ll pay in interest that month. If you have a $5,000 loan balance, your first month of interest would be $25.
- Subtract that interest from your fixed monthly payment to see how much in principal you will pay in the first month. If your lender has told you that your fixed monthly payment is $430.33, you will pay $405.33 toward principal for the first month. That amount gets subtracted from your outstanding balance.
- For the following month, repeat the process with your new remaining loan balance, and continue repeating for each subsequent month.
Here’s an example of how a $5,000, one-year personal loan with a 6 percent fixed interest rate amortizes:
|Payment Date||Payment||Principal||Interest||Total Interest Paid||Remaining Balance|
Factors that affect how much interest you pay
There are many factors that can affect how much interest you pay for financing. Here are some of the primary variables that can impact how much you will pay over the life of the loan.
The amount of money you borrow (aka your principal loan amount) has a big influence over how much interest you pay to a lender. The more money you borrow, the higher your interest fees.
If you borrow $20,000 over five years with a 5 percent interest rate, you’ll pay $2,645 in interest on an amortized schedule. If you keep all other loan factors the same (e.g., rate, term and interest type) but increase your loan amount to $30,000, the interest you pay over five years would increase to $3,968.
“The higher the loan amount, the more risk the lender assumes. However, they also get a higher return because the borrower pays more interest,” says Laura Sterling, vice president of marketing for Georgia’s Own Credit Union.
Who this affects most: This factor significantly impacts individuals taking out large loans. They will pay far more in interest in order to borrow the money from a lending institution.
Takeaway: Don’t borrow more than you need to. Crunch the numbers first and determine exactly how money you really require.
Along with the amount of your loan, your interest rate is extremely important when it comes to figuring out the cost of borrowing. Poorer credit scores typically equal higher interest rates.
Building on the previous example, let’s compare a 5 percent loan with a 7 percent loan ($20,000, five-year term, amortized interest). On the 5 percent loan, the total interest cost is $2,645. If the interest rate increases to 7 percent, the cost of interest rises to $3,761.
You will also need to find out whether your loan features a fixed interest rate or a variable interest rate. If it’s variable, your interest costs could rise over the course of your loan and affect your overall cost of financing.
Who this affects most: If you have a less-than-ideal credit score, lenders will charge a higher interest rate in exchange for the risk they’re taking lending you money. This means that the loan will end up costing you more money.
Takeaway: It may make sense to work on improving your credit score before borrowing money, increasing your odds of securing a better interest rate and paying less for the loan.
A loan term is the amount of time a lender agrees to stretch out your payments. So if you qualify for a five-year auto loan, your loan term is 60 months. Mortgages, on the other hand, commonly have 15-year or 30-year loan terms.
The number of months it takes you to repay the money you borrow can have a significant impact on your overall interest costs.
In general, shorter loan terms lead to higher monthly payments but will mean less interest paid over the life of the loan. Longer loan terms, on the other hand, may reduce your monthly payment size, but because a longer term stretches out the repayment timeline, you’ll pay more interest over time, thus increasing the overall cost of borrowing the money.
Who this affects most: Borrowers already on a tight budget will want to weigh their loan term options carefully, as shorter loan terms will result in much higher monthly payments and have a more significant impact on monthly cash flow.
Takeaway: Be sure to crunch the numbers ahead of time, figure out how much of a payment you can afford and find a loan term that makes sense for your budget and overall debt load.
How often you make payments to your lender is another factor to consider when calculating interest on a loan. Most loans require monthly payments (though weekly or biweekly payments exist too, especially in business lending). If you opt to make payments more frequently than once a month, there’s a chance you could save money.
When you make payments more often, you may reduce the principal owed on your loan amount faster. In many cases, such as when a lender charges compounding interest, making extra payments could save you a lot.
Who this affects most: Making payments more frequently can be beneficial for those who want to eliminate the debt quickly and have the cash flow to be able to do so. If this is your plan, be sure you find a loan that does not include an early repayment penalty.
Takeaway: Don’t assume you can only make a single monthly payment on your loan. If you want to reduce the overall interest you pay to borrow money, it’s a good idea to make payments more often than required.
The repayment amount is the specific dollar amount you’re required to pay on your loan each month.
In the same way that making loan payments more frequently has the potential to save you money on interest, paying more than the required minimum monthly due can also result in some savings.
Who this affects most: If you are able to make more than the minimum payment on your loan, you can resolve your debt more quickly and cut down on your total interest payments.
Takeaway: If you’re thinking about adding additional money to your monthly loan payment, ask the lender if the extra funds will count toward your principal. If so, this can be a great strategy to reduce your debt and lower the amount of interest you pay.
The bottom line
Figuring out the true cost of interest on a loan or credit card can seem difficult. But in truth, once you know the type of interest you’re paying, you can use a financial calculator online that will help you crunch the numbers.
When it comes to credit cards and other loans, remember that paying off your balance faster can potentially save you a lot of money in interest fees. With credit cards in particular, paying your full statement balance by the due date each month usually helps you avoid interest altogether.
Source: MSN Money / Featured image by freepik