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How to Calculate Interest on a Loan: A Step-by-Step Guide

How to Calculate Interest on a Loan: A Step-by-Step Guide

So you’ve decided that you’re going to take out a loan. Now what? Here’s what you’ll need to know in a step-by-step guide that’ll help you calculate interest on your loan, and know what you’ll be paying back in five easy steps.

Step One: Name Your Number!

Determine Your Principal And Establish How Much Money You Want

Your principal is the initial amount you decide that you’re going to borrow. The amount of your principal will also determine what your interest will be like at the end of the loan. Whether you’re going big or small, it’s always better to stick to borrowing only what you’ll need.

What’s the lowest and highest amount of money you’d accept for your loan? What are you going to use the funds for? How are you going to budget that money? When do you plan to start paying it back? Will you have enough money to pay off the loan with the interest added on? Can you make your payments on time?

These are all questions you should be asking yourself before you settle on your principal amount and apply for that loan. It’s important to be ready for the responsibility that’s about to be handed to you. Loans have the potential to both help and hurt a borrower, depending on how it’s handled.

Step Two: Which Loan is Right For You?

Determine the Type of Loan You Want to Calculate Interest For

Different kinds of loans will accumulate different kinds of interest rates, so in order to calculate that interest on your loan, you’ll need to settle on a type of loan. There’s a varying range of pros and cons to every kind of loan… it really just depends on what you’re looking for and your own individual set of needs in a loan.

For example, you could choose to have either lower interest rates or lower payments. If you go with the first option, you’ll obviously have a small amount of interest due at the end of your loan and less interest attached to each individual payment. But you’ll also have to juggle more expensive and more frequent payments on your loan.

Or if you choose the second of those two options and opt for lower payments rather than lower total interest, you’ll pay less money, less often. But you’ll have a higher total interest rate to manage and you’ll have to worry about all that interest multiplying and stacking up if you don’t make your (lower) payments on time.

The first option is better for borrowers with a slow but steady monthly income, while the second would be better for borrowers who are paid on commission or contract and receive large amounts of money in less frequent bursts.

Your interest rate on your loan can also be affected by your credit score and how long you want to take out a loan for. If you’re planning on have a long-term loan over the course of a year, you’re probably going to have lower interest rates versus a short-term loan that has fewer payments, but with higher interest rates attached. It all just depends on your personal preferences – it’s rare that any one loan is “better” than another… they just do different things for different people.

There are countless different types of loans for you to choose from:

  • Mortgage loans
  • Car title loans
  • Student loans
  • Appliance loans
  • Payday loans
  • Personal loans
  • Veteran loans
  • Small business loans
  • 401 K or life insurance loans
  • Consolidated loans
  • Informal friend/family loans
  • …and then some!

Some types of loans utilize the value of collateral. For example, you could use your major appliances, cars, or even your home to finance a loan using their equity or collateral value. This is best for borrowers with a poor credit score, or for those who’ve previously filed for bankruptcy (which can hurt your chances for being eligible for many types of loans). These are often short-term loans with higher interest rates, but can be done quickly and conveniently. Rather than selling these high-value assets, they allow borrowers to access the equity or value of the asset for a certain amount time, then simply pay back the loan.

Other loans use the money that’s saved in your life insurance policy or retirement plan. Many small businesses are eligible for loans that individuals are not, just as veterans or disabled citizens might be eligible for types of specialty loans with different rates.

Know what you kinds of loans you’re qualified to receive, and what certain types of loans will offer you. There’s a pretty even system of give-and-take with the benefits and drawbacks of loan types, so know what you’re looking for, whether it’s lower interest rates and a longer term, or more funds with a shorter term, etc.

You can calculate how much you’ll owe plus interest on each payment of your loan with this formula:

Payment = Principal X i(1+i)n/(1+ i)n – 1

(i= your interest rate) (n=number of payments)

Step Three: How Much Interest Will You Have On Your Loan?

Understanding Your Interest Accrual Rate

The accrual rate of your loan will determine how often you have to make payments on your loan, and is determined by your lender (and the type of loan you decide to pursue).

It’s all pretty common sense stuff: if you pay less frequently, you’ll pay in larger amounts. Or you could pay more often in small installments.

Your loan’s accrual rate will also become a factor in the compounding rate of interest. The compounding rate of interest is the amount of interest you’d have to pay on interest already accrued. It works like this:

Every time the lender calculates the interest on your loan that you owe, it’s tacked on to the subtotal that is the principal amount. So every time you accrue more interest with each payment, the additional interest is added on to that total amount. Generally speaking, the longer you’re stuck accruing interest, the more it compounds on that interest rate, so you’ll wind up owing a considerable amount more money.Calculate Interest on Loan

Your interest could compound monthly, yearly, bi-monthly… it all just depends on the type of loan, and what was agreed upon when you accepted the terms of the loan; so take note.

Here’s the formula to calculate the compound interest on your loan:

P = principal amount (the initial amount you borrow or deposit)

r  = annual rate of interest (as a decimal)

t  = number of years the amount is deposited or borrowed for (term/time)

A = amount of money accumulated after n years, including interest.

n  =  number of times the interest is compounded per year (how many payments you make where interest is due)

The lender might quote you at two different types of interest rates, so it’s important to pay close attention to how they phrase it. There is Annual Percentage Rate (APR) and the Annual Percentage Yield (APY). They mean different things for you. Sneaky, right? Definitely annoying. There are handy online calculators for helping you determine your APR, like this one. You can also use another online calculator to convert your APR to APY, so you can understand your Annual Percentage Yield if that’s what your lender chooses to quote you with.

There you have it. You now understand your interest accrual rate (which you learned from your lender), your compounding interest rate, and how to calculate your interest rate on a loan when factoring in your APR and/or APY. You’ve got this loan on lock!

If you want to calculate how much total interest you’ll have to pay on the full term of your loan, you can just the principal from the total amount you’ll pay using that first formula of: Payment = Principal X i(1+i)n/(1+ i)n – 1

Make sure you’re factoring in the number of payments you’ll make (monthly, annually, weekly, etc.) which will also determine the number of times you accrue interest over the life of the loan.

Step Four: How Much Are You Actually Paying for Your Loan If It Amortizes?

Breaking Down the Amortization of Your Loan

If you want to calculate how much interest you’re paying with each individual payment on your loan rather than total interest over the life of the loan, you’ll need to understand amortization.

This is the most practical and useful definition of amortization that we’ve seen:

Amortization is the elimination of a debt over time with periodic payments. For example, assume you make mortgage payments every month. A portion of that payment covers the interest you owe, and a portion of the payment pays down your principal. The majority of each payment at the beginning of an amortization loan pays for interest. As time goes on, more and more of each payment covers your principal. You are then “amortizing” the loan.”Calculate Interest on Loan

If you want calculate the amortization of your loan, you can use this helpful calculator. Not all loans are amortizing loans, but you’ll need to understand the process of amortization if it’s relevant to you/your loan.

Step Five: Keep On It!

Staying on Top of Your Loan: Tools and Tricks

In order to successfully calculate (and then successfully pay off) the interest on your loan, you’ll need to carefully plan and regulate how you intend to pay off that loan in full.

While every loan is going to work a bit differently (and therefore you often calculate interest on that loan differently) there are some general blanket tools that can help you calculate how much you’ll owe over a determined period of time.

You’ll need some of the basic information about the terms of your loan handy. If you haven’t taken out your loan yet, try plugging in for various scenarios using different loan terms.

Try to calculate what a payday loan will cost and/or provide you versus a personal loan, and so on. This will give you a better understanding of what you’re getting yourself into, and thus help you settle on a type of loan that works best for you.

Understanding the full cost vs benefits of different types of loans is what will help save you money and stress in the long-run. Weighing those pros and cons of various kinds of loans will make a world of difference when it comes time to make the first payment installment.

Try basic, generic loan calculators such as this one. Or you can calculate your daily interest on your loan, so you can determine how much money you’d save by paying off your loan earlier. (The general rule of thumb to avoid that accruing and compounding of interest is to pay off your loan as soon as you can without completely breaking the bank). Your daily interest rate factor is what adds up when you aren’t looking.

Other calculators such as this one can help you calculate the full cost plus interest on your loan when factoring in your APR.

It’s a necessary, but often intimidating thing trying to calculate interest on a loan. Especially when you consider all the different variables that could affect that interest and the total you’ll pay for your loan, such as different loan type, the length of your loan, terms, fees, accruing and compounding interest rates, frequency of payments, and more.

The universal tool calculator that you can use to calculate the interest on a loan might already be installed on your computer. Excel can easily and automatically calculate most kinds of interest on your loan, once you know the specifics and break it down. When you use Excel to calculate and keep track of payments and interest on your loan, you’ll also have an easier and more organized tool to help you manage your loan. It can even help you de-mystify your amortizing loan if you need it to. Here’s a helpful guide to get you started.

Managing your loan is the most difficult part of the lending process; not learning how to calculate interest on the loan itself! It’s the daily tracking and balancing of interest rates and payments that requires your full attention. If you don’t make your payments on time, that’s when that interest you’ve been accruing begins to compound, and you could quickly get into trouble. Complete your payments in full and on time (as per discussed in the terms of your loan) and you’ll come out without a scratch, and in the green!

Scott Carver
Scott Carver
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