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How to Calculate Interest on a Loan
●January 6, 2021●4 minute read
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It’s not uncommon for Aussies to seek the financial aid of a bank or financier to loan them some money to afford big purchases. These big purchases are often typically assets like cars, houses or a combination of both such as a motorhome. These items are usually expensive to purchase, so instead of having for years, most people would rather take out a loan. When you borrow money from a financier, the lender charges interest on the use of the funds for a particular time, and when you finally pay up, you have to include both the principal and the interest.
The term interest rate is a recurring variable when it comes to a loan because it is an incremental part of determining how much you will eventually have to pay back. It’s essential to learn how to calculate loan interest because it informs your decision when selecting an option. So that’s what we’re going to tackle today.
What is interest?
Let’s say Todd borrows $100 from his good friend Sarah. Now, Sarah knows Todd is perfectly capable of paying her back, but because she’ll have to do without the $100 for about a week or so, she asks him to pay her back $105. The $5 difference Todd has to pay is the interest. Simple, right? Well, with home and car loans that typically run into thousands of dollars, it might seem more complicated, but it works on the same principle.
Still using our example, let’s say Todd agrees to Sarah’s terms and decides to pay her part of the money every day. Well for him to pay up in a week, he has to give Sarah $15 each day. If we break that down, $14.28 will go to paying back the amount he borrowed, while $0.71 would go to covering the interest. Of course, the difference between how much goes to the principal and the interest depends on more factors than only Sarah’s whim on a larger scale. Professional money lenders calculate their interest rates using a variable like the duration of the loan, the principal amount, and the financial history of the person in question.
Calculating interest on a loan
There are two main ways lenders arrive at their figures, and at times it depends on the kind of loan. But don’t worry, we’ll get to both of them. Let’s start with the easier one first
The simple interest method often applies to more short-term loans. To calculate the simple interest, you must know:
- The principal
- The interest rate charged per year
- Time in years
The formula is the same as the one you’re probably familiar with in algebra, which is:
I = Prt
I = simple interest
P = principal
R = interest rate per year
T = time in years
So for example if you got a $40,000 loan for four years at a rate of 6%, the interest you would have to pay would be:
$40,000 x 0.06 x 4 = $9600
As you can see, we need to represent t in years, and r as a decimal number (divided by 100), to get the right figure. Now let’s look at the more complex method of finding interest.
It’s more common for moneylenders to charge their interest using an amortization calendar, so pay close attention. Your personal, car and at times, even student loans fall into this group. In our earlier example, we assumed that each day Todd paid $15 to Sarah, $14.28 of it covered the principal, while $0.71 of it went to the interest. Well, with an amortizing loan, those figures vary every month. Don’t be alarmed. It’ll in no way affect how much you have to pay unless you’re using a variable interest rate. But if the rate is fixed, Todd will still pay $15 every day. The ratio of principal to interest is what changes, and here is how you calculate it:
(r/n) x P = I
Remember from above that r stands for interest rate per year, P is our principal, and I is our interest. But now we have a new variable called n, which stands for the number of payments. To adequately explain amortizing loan, let’s use our previous example of a $40,000 loan for four years at a rate of 6%.
So here’s what you would have:
(0.06/48) x 40,000 = $200
N is 12 here because if you’re making monthly instalments throughout the four years, you would have twelve payments to make.
So our result implies that out of your monthly payment for the first instalment, $200 would cover the interest, so here’s how you calculate the interest in the next payment:
P – (repayment – I) = new balance
You then go on with this method till you completely pay off your loan. The easiest way to break it down is in a table:
As you can see on the table, the amount that goes towards interest decreases steadily as the principal amount increases, but the monthly payments remain the same. That’s an indication that with the amortization schedule, the earlier fees are more interest-heavy, while the latter costs are more principal-heavy. The total interest paid over time will amount to $1,311.89, but there’s a unique and more complex formula for arriving at that figure.
Of course, if you’re not a fan of algebra, you can skip calculating interest rates yourself altogether and opt for a spreadsheet or online amortization schedule calculator. Whatever works for you now have the basic knowledge of how to calculate loan interest.
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Written by Jacaranda Team