How To Calculate Interest on a Loan
Interest is the amount of money a lender will charge you to take out a loan. Lenders make a profit by charging consumers interest and fees on the loans they borrow. Interest is commonly calculated in two ways: simple and amortizing interest.
How much you’ll pay in interest will depend on a variety of factors, including the type of loan, your credit score, the loan length and the type of interest.
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How to calculate interest on a loan
Interest is the price you pay in exchange for borrowing money. A loan’s annual percentage rate (APR) is simply the combination of the interest rate and any applicable fees, such as an origination fee. Interest rates are measured as a percentage and largely depend on factors like your credit score, the lender and the type of loan.
Interest is calculated in one of two ways: simple interest and amortizing interest. While amortizing interest is more common, it’s important to understand each and how they can impact your wallet.
Which loans use simple interest?
This type of interest isn’t common in traditional lending, but you may find simple interest on payday loans, car title loans and installment loans. Some personal loans or certain vehicle loans may use simple interest, but this is rare.
How to calculate simple interest
To determine the simple interest on a loan, the calculation is straightforward:
Principal x interest rate x repayment term = interest amount
For example, if you borrow $10,000 at 7% interest over a three-year term, you’ll end up paying $2,100 in interest: $10,000 x 0.07 x 3 = $2,100
Which loans use amortizing interest?
This type of interest can most commonly be found with personal loans, mortgages and auto loans. Other types of loans that may come with amortizing interest include debt consolidation loans, home equity loans and student loans.
How to calculate amortizing interest
Calculating amortizing interest can be a bit complex. Here are the steps you’ll need to take:
- Divide your interest rate by the number of monthly payments you’ll make in one year. If your loan has 18% interest and you plan to make one payment each month, you’ll divide 0.18 by 12 to get 0.015.
- Next, multiply that number by the balance you have left on the loan. So, if you have $5,000 left on your loan, you’ll multiply $5,000 by 0.015 to get $75. This means that $75 of this month’s loan payment will go toward interest.
- Then, you’ll subtract that $75 from your monthly payment to understand how much you’re paying toward your principal. If, for instance, your fixed monthly payment is $350, $275 will go toward your principal. Subtract that amount from your current balance to determine how much you still owe on the principal. So if you started the month owing $5,000, your monthly payment will bring the amount you owe to $4,725.
- Repeat these steps for future monthly payments. Notice how a larger percentage of your total payment goes toward the principal with each passing month, while your interest payments get smaller.
Using a loan calculator
While these calculations can be done with a pen and paper or the calculator on your phone, you can also use LendingTree’s loan calculator to help reduce errors and simplify the process. Be sure to review the table to understand the impact of amortization on your monthly payment.
How are interest rates determined?
Lenders determine the amount of interest you’ll pay on your loans by assessing a variety of factors. When you apply for a loan, your lender will review your credit score and the activity on your credit reports to determine your creditworthiness. Your interest rate can also be affected by how much you borrow, how often you make payments and how long you have to repay your loan.
- Credit score: Lenders view your credit score as an indicator of the amount of risk you present as a borrower. The higher your credit score, the less risky you appear and the lower the interest rates lenders are likely to offer.
- Credit history: When lenders perform a hard credit pull, they can view the activity on your credit reports. This includes your payment habits, how much debt you have and the length of your credit history. Lenders use this information to assess how likely you are to repay your loan and whether they’d want to accept you as a borrower.
- Loan amount: The larger your loan amount, the more you’re likely to pay in interest — larger loans may be more challenging to repay, and as such they increase the risk of default. This is why it’s important to only borrow what you need.
- Repayment term: Long loan terms may come with lower monthly payments, but you’ll pay more in interest over the life of the loan. It’s generally wise to choose the shortest repayment term you can comfortably afford.
- Collateral: Secured loans, like auto loans or mortgages, require collateral as a way to guarantee repayment. The risk to the lender is decreased with a secured loan because if you fail to make your loan payments, the lender can seize your asset to recoup their losses. As a result, secured loans often come with lower interest rates. Since the risk is greater on an unsecured loan, they typically have higher interest rates, increasing the total amount you’ll pay over the loan’s repayment term.
Average personal loan interest rates
Knowing your credit score can give you an idea of how much you can expect to pay in interest for a loan. Review the table below to see the type of rate you may qualify for on an unsecured personal loan.
|Credit score range||Average APR||Average loan amount|
|Less than 560||185.17%||$2,482|
Source: LendingTree user data on closed personal loans for the second quarter of 2023
How to get the best interest rate
When shopping for loans, it’s important to get preapproved with multiple lenders to compare the best rates and features. Shopping around for the best deal can lead to serious savings. In fact, a 2023 LendingTree study found that car buyers saved an average of $5,198 by shopping around and choosing the loan with the lowest annual interest rate.
To ensure you get the lowest available rates, you’ll need to have a good credit score. If your credit needs work, you should work to improve your credit score before applying for new credit. Paying down on current debts and making all payments on time will help to boost your score over time.
But improving your credit score won’t happen overnight. If you’re in urgent need of a loan, consider applying with a cosigner or co-borrower who has strong credit. You may also have an easier time getting approved for a secured loan, as long as you have an asset to offer as collateral, like a savings account or vehicle.