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Understanding how interest is calculated on a personal loan is essential for managing your finances and planning repayment. Whether you’re considering a loan or already have one, knowing how interest accrues helps you estimate total costs and monthly payments. This guide breaks down the methods used to calculate loan interest, including both simple interest and amortized interest.
What Is Interest on a Personal Loan?
Personal loans consist of two things: The principal, which is the amount you are borrowing, and the interest. Interest is what the lender charges you to borrow the money. In other words, interest is the price you pay for taking out the loan. Although APR vs interest rate are terms that are often used interchangeably, they are different. Interest is the percentage of the loan amount paid to the lender. APR is the interest rate plus any additional fees charged by the lender.
Types of Interest on a Personal Loan
There are different types of interest for personal loans. Two of the common types are simple interest and amortized interest.
Simple Interest on Personal Loans
Simple interest is most commonly used for short-term personal loans. With simple interest loans, the monthly payment is fixed, but the interest you pay each month is based on the outstanding loan principal balance. As you continue to pay off the loan, you pay less in interest.Simple interest loans are most beneficial to borrowers who make payments on-time or early. If you pay off the loan early, you can save money that you would have paid in interest. However, some lenders may charge prepayment penalties, so you should check your terms and conditions before paying off a loan early. In contrast, precomputed interest personal loans calculate how much interest a borrower will pay if the loan extends through the entire loan term. This is calculated at the beginning of the loan. That total amount is added to the principal to create the balance. Then the monthly payment is calculated by dividing the new balance by the number of payments. With precomputed interest loans, the first loan payments you make have higher interest than the payments at the end of the loan. Precomputed interest loans are not common, but it’s good to know about them.
Amortizing Interest on Personal Loans
For personal loans with amortized interest, the way interest is charged changes over the life of the loan, based on what’s called an amortization schedule. Loans like mortgages, auto loans, debt consolidation loans, and student loans often use amortizing interest. Although the interest changes on loans with amortized interest, the monthly payments on these loans are fixed and the loan is paid over time in equal installments. When you make payments on an amortizing loan, more of your money will go toward interest at the beginning of the loan term than at the end. That means less money goes toward the principal loan amount at the beginning since more is going toward interest. However, the ratio changes as the loan term progresses. Toward the end of your loan, most of your monthly payments will be applied to your principal balance.Lenders tend to benefit more from amortized interest loans. The length of the loan is extended because payments are applied to both principal and interest. This increases the amount of interest that is paid to the lender over time.
How Is Personal Loan Interest Calculated?
As discussed, personal loans tend to use simple interest or amortized interest. Simple interest is calculated with a straightforward formula, while amortized interest is a bit more complex. Here’s how each is determined.
Simple Interest Formula
The formula for calculating simple interest is: Loan Principal x Interest Rate x Loan Term = InterestFor example, if you take out a five-year loan for $10,000 and the interest rate is 10%, the formula would be:$10,000 x 0.10 x 5 = $5,000 in interestYou will need to know your loan principal, which is the amount of money you agreed to borrow. You also need to know what your interest rate is. You can find both of these numbers in the terms of your loan agreement. Recommended: $10,000 Personal Loan
Amortized Interest Formula
With amortized interest, the interest changes over the life of the loan. Typically, you pay more in interest at the beginning of the loan. To calculate amortized interest, divide your interest rate by the number of payments you will make that year. Then multiply that number by your remaining loan balance to find out how much you will pay in interest that month. (Interest Rate / Number of Payments) x Loan Balance = Amortized InterestSo, for example, on a five-year loan for $10,000 and a 10% interest rate, the formula would be:0.10 ÷ 12 = .0083 x $10,000 = $83.33 in interestTo determine how much you will pay toward the principal that month, subtract the $83.33 in interest from your fixed monthly payment. For instance, if your fixed monthly payment is $240, the formula would be:$240 - $83.33 = $156.67 toward the principal Subtract that amount from your outstanding balance to get your new remaining loan balance:10,000 - $156.67 = $9,843.33 new loan balanceRepeat the process for each subsequent month with the new remaining loan balance.
Why It's Important to Know How Personal Interest is Calculated
Knowing how personal loan interest is calculated helps you understand how much of your payment is going toward the principal and how much is going toward interest. The average interest rate on a personal loan varies by lender. Your interest rate is based on your credit score, credit history, income, debt-to-income (DTI) ratio (which is your monthly debts compared to your gross monthly income), loan term, and loan amount, among other factors. In general, the higher your credit score, the lower your interest rate will be. To improve your chances of getting a lower interest rate on a loan, you should work to keep your credit strong and reduce your debt-to-income ratio. You can improve your DTI by decreasing your debt and increasing your income. Ideally, your DTI should be lower than 36%. Applying for a shorter-term loan could also help you get a lower interest rate. As long as you can afford the monthly payments, you will save money by paying less interest over time.
The Takeaway
If you are taking out a personal loan, you should know how to calculate the interest on the loan to know how much of your payment is going toward the principal and how much is going to interest each month. Understanding interest will also help you see how much you will end up paying in total by the end of the loan.Exploring personal loans could be a good way to find a favorable interest rate. Lantern can help you easily compare options from multiple lenders all at once in one place to find the right loan terms for you.
Frequently Asked Questions
How do I calculate interest on a personal loan?
Is personal loan interest calculated monthly?
What is the formula for interest calculation?
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About the Author
Jason Steele
Jason Steele has been writing about credit cards and award travel since 2008. One of the nation's leading experts in this field, he has contributed to dozens of personal finance and travel outlets and has been widely quoted in the mainstream media.
