How To Calculate Interest On A Loan

7 Min Read
Published May 29, 2024
FACT-CHECKED
Written By
Rory Arnold
Reviewed By
Tom McLean
A man and a woman sitting in front of a laptop calculate loan interest.

When you take out a loan or mortgage, your lender charges you interest on the amount you borrow. How much interest you pay depends on the interest rate and how the interest is calculated. Understanding how interest is calculated will help you better understand the terms of your loan and prepare you to choose the right one for you.

Key Takeaways:

  • The cost of borrowing money usually is calculated using simple interest or amortizing interest.
  • The difference between simple and amortizing interest is how each loan payment is divided between principal and interest.
  • You can improve your chances of getting a lower interest rate by reducing your debts, increasing your credit score or buying mortgage points.

How Is Interest Calculated On A Loan?

There are two common ways to calculate interest on a loan: simple interest and amortizing interest.

Simple Interest

With simple interest, the amount you pay in interest is determined only by the original loan amount and remains constant with each payment until the loan is paid off.

Because you pay the interest in equal installments, paying off the balance ahead of schedule can save you money by reducing the interest you pay. Some lenders may charge a prepayment penalty in such cases to compensate for the interest they won’t receive from additional payments.

Simple interest loans have shorter terms and are typically used as short-term funding solutions.

Amortizing Interest

With an amortizing loan, the portion of your monthly payment that goes toward interest changes.

When you start repaying the loan, most of the payment will go toward interest, with a smaller portion applied to the principal. Each payment recalculates the interest based on the amount owed, so the amount that goes toward interest declines with each payment, and more is applied to the loan balance until the loan is repaid in full.

Your lender will provide an amortization schedule that shows how each payment is divided between principal and interest. It also will show you your loan balance after each payment, and how much interest you’ll pay overall for the loan.

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Calculating Loans With Simple Interest

To calculate your total interest paid with a simple interest loan, you’ll need three key figures:

  • Principal.
  • Interest rate.
  • Loan term.

Multiply each figure to figure out the total interest you’ll pay.

Principal loan amount x interest rate x loan term = total interest

Add the interest to the principal to get the total amount owed, and divide by the number of payments to get the monthly amount due.

Total amount owed / number of monthly payments = monthly payment amount

Example Simple Interest Calculation

Let’s say you take out a $40,000 loan with a 6% interest rate and a five-year loan term. Multiply your loan amount by your interest rate and loan term to find out how much interest you’ll pay.

$40,000 x 0.06 x 5 = $12,000

That gives you a total repayment amount of $52,000. Divide that by the number of payments – 12 monthly payments over five years totals 60 payments – to get the monthly payment.

$52,000 / 60 = $867 per month

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Calculating Loans With Amortizing Interest

Calculating interest on a loan with amortizing interest requires these key figures:

  • Principal.
  • Interest rate.
  • The monthly payment, which requires the loan term and can be calculated separately or by using a mortgage calculator.

How each payment is divided between interest and principal changes with each payment. To calculate the current payment on an amortizing loan, multiply the balance by the interest rate.

Principal balance x interest rate = annual interest amount

Then, divide that by the number of payments you make each year to see how much you’ll pay in interest for the current month.

Annual interest amount / number of months = interest fee for this payment

Next, subtract that from your monthly payment amount to see how much goes toward the principal.

Monthly payment – interest fee for this payment = principal paid for this payment

With amortizing interest, the interest is recalculated every month. So, after deducting the principal paid for this payment from the loan amount, you calculate the next payment using the updated loan balance. This continues for each payment until the loan is paid off.

Example Amortizing Interest Calculation

Let’s say you’re buying a $400,000 home with a 20% down payment. You take out an amortizing 30-year fixed-rate mortgage for $320,000 with a 6% interest rate. Your fixed monthly payment for principal and interest will be $1,919. This doesn’t include property taxes or homeowners insurance, which many homeowners pay with a monthly add-on to their loan payment into an escrow or impound account.

Start by taking your loan balance and multiplying it by your interest rate.

$320,000 x 0.06 = $19,200

Since you’ll be making 12 monthly payments, divide $19,200 by 12.

$19,200 / 12 = $1,600

This means that in the first payment, $1,600 goes toward interest. If you subtract that from the total monthly loan payment, you’ll know how much will go toward the principal.

$1,919 – $1,600 = $319

Subtract this amount from your outstanding balance to see your remaining balance.

$320,000 – $319 = $319,681

This will be your starting balance for calculating the next month’s payment.

Amortization Tables

With most mortgages repaid over 15 or 30 years, you may not want to do that much math. An amortization calculator can do the work for you and generate an amortization table quickly that’ll show how each payment is divided.

An amortization table usually looks something like this:

Amortization Schedule For A $320,000 Loan With A Fixed 6% Interest Rate

MonthPayment AmountPrincipal PaidInterest PaidCumulative InterestBalance
1$1,919$319$1,600$1,600$319,681
2$1,919$320$1,598$3,198$319,361
3$1,919$322$1,597$4,795$319,040
4$1,919$323$1,595$6,390$318,716
357$1,919$1,881$38$370,625$5,699
358$1,919$1,890$28$370,654$3,809
359$1,919$1,900$19$370,673$1,909
360$1,919$1,909$10$370,682$0

How To Get A Lower Interest Rate

A lower interest rate reduces your monthly payment and the amount you pay overall for your loan. Just a fraction of a percentage point can save you thousands of dollars over the life of your loan. Here are some ways you may be able to get a lower interest rate on your mortgage:

  • Improve your credit score. Borrowers with a higher credit score get lower interest rates. You can boost your credit score by making payments on time, catching up on past-due accounts and paying down debts.
  • Lower your debt-to-income ratio. Your DTI ratio reflects how much of your income is eaten up by your existing debts. You can reduce your DTI ratio by paying down your debts or increasing your income.
  • Take out a short-term loan. Loans with longer repayment terms tend to have a higher interest rate than short-term loans. If you can afford the higher payment, you can reduce the interest rate and the total interest paid with a 15-year versus 30-year mortgage.
  • Shop around. Comparing mortgage offers also can help you score a lower interest rate. Use the Loan Estimate your lender provides when you apply for a loan to compare terms and pick the offer with the lowest overall cost.
  • Sign up for automatic payments. Scheduling automatic mortgage payments to match your pay cycle can prompt some lenders to offer a lower interest rate.
  • Buy mortgage points. You can reduce the interest rate on your loan by paying for mortgage points at closing. Points allow you to pay interest upfront in exchange for a lower rate and can save you thousands over the life of your loan.
  • Add a co-signer with a higher credit score. If your credit isn’t so great, adding a co-signer with better credit to your loan application can get you a better interest rate. Remember that your co-signer will be responsible for paying the loan if you cannot do so.

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The Bottom Line

Borrowing money costs money, so knowing how much you’re being charged is important. Whether it’s a simple interest or amortizing loan, it’s also prudent to understand how much each payment you make chips away at the principal balance and how much goes toward interest. You also can take steps to improve your chances of getting a lower interest rate that will save you money on your loan.

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