People who take out loans generally understand that they are paying both the principal amount of the loan and the interest. What they might not fully understand is how much of their weekly, bi-weekly or monthly payments on the loan is interest.
If you have a particularly simple loan, figuring out the interest you will owe on it is, fittingly, simple. And if you have a calculator everything is easy as can be. But what if you're not sure of the formula and you're trying to figure out the interest on this loan? Not to mention the fact that as the amount owed on a loan changes, it only makes sense that the interest does. Plus, not every sort of loan operates in the same way.
Here's what to know about figuring out the interest on your loan.
Formula for Calculating Interest on a Loan
Many types of loans - including student loans, mortgages, car loans and business loans - go through a process called amortization. Amortization, in the context of repaying loans, is when the principal and interest are combined into a fixed amount to be paid at a consistent rate (often monthly) for a predetermined amount of time.
That means when you're making a loan payment, when just looking at the amount you don't know how much is the principal and how much is interest. But you can take it apart and figure it out.
First, you'll need several figures handy before you can calculate the interest. Those are:
- The amount owed on the loan
- The interest rate
- The amount of time you're paying the loan
- The monthly payment
So let's say you have a business loan of $30,000 over 10 years with a 6% interest rate. According to the provider of this loan, you'll be paying $333 dollars monthly on this loan. How much of that is interest?
Because the interest rate on this loan is 6%, and you're making payments on a monthly basis, let's use this formula to calculate interest:
(Interest rate/12) x loan amount = interest amount
We're using 12 because we're dividing the yearly rate by the amount of times you're making a payment in the year, which in this case is monthly. If you were paying weekly or bi-weekly, it would be different.
So first we divide 6%, aka 0.06, by 12, which equals 0.005. 0.005 multiplied by $30,000 = 150.
$150 of that first $333 loan payment is interest, meaning that you've paid $183 of the principal.
How to Calculate Interest With an Amortization Table
You may have noticed that all of that was to calculate only the interest on the initial payment. Now that you've paid $183 of the loan amount, the new amount you have left is $29,817. Which means we now have to do the entire calculation again to see how much interest is being paid in the second payment. And the third payment, and the fourth and so on until the loan is paid.
To keep track of how much of a loan payment is interest and principal, and how much of the loan is left, some may be inclined to use an amortization table. Also known as an amortization schedule, this table breaks apart the specific elements of your loan so you can see the full breakdown of what you're paying, where that payment is going and how much you have left.
If we continue with this business loan example, using an amortization table the breakdown would start off approximately like this:
|Month||Starting Balance||Payment||Interest Paid||Principal Paid||Balance Remaining|
And so on and so forth through the full 10 years. By the end of those 120 payments, you will have paid an estimated $9,967 in interest on this $30,000 loan.
How to Calculate Simple Interest on a Loan
This can all be a little complicated and unwieldy. If you have a loan with simple interest, luckily everything is far easier to manage.
Simple interest is best used with short-term loans. Calculating the aforementioned 10-year business loan or an even longer loan with simple interest isn't going to give you an accurate result. With a bank loan that lasts one year, a simple interest calculation may be best.
The formula for finding simple interest on a loan is:
Principal x Interest rate x Time amount = Simple interest
So if we stick with a one-year bank loan as an example, let's add onto that. Say this loan is worth $150 with 5% interest. Plug everything in: $150 x .05 x 1. The answer to this is that you'll be paying $7.50 in interest on this loan.
Simple interest calculations can be limited in the loans they work for, but in a case like this it's very helpful and lets you avoid the continuing calculations over time.
How to Calculate Interest on Credit Cards
Calculating the interest on your credit card can be a little trickier. You don't have a set, unchanging credit card balance since you can add to it, and you'll need to find out how much interest gets added every day of the year.
An important thing to know is that most credit cards don't charge interest monthly, but daily. So just knowing your annual percentage rate (APR) is not enough; you'll need to know the daily percentage rate as well. Let's say you have a balance of $700 on your credit card with an APR of 14%. If you don't add anything to the balance or pay any of it off before the end of the month, you'll average $700 over 30 days.
We'll have to figure out the daily percentage rate by dividing 14%, or 0.14, by 365. That gives us 0.00038356, or 0.038356%. If we multiply $700 by the daily percentage rate, we end up with 0.268. Multiply this by 30, and you can estimate that you would pay approximately $8.04 in interest that month.
If you never add to that balance, it will continue to average the same amount. But what happens if the balance changes? Say 20 days into this month, you charge an additional $200 to the card, bringing you up to $900. Now you'll have to calculate the average balance you had that month on a daily basis.
For 20 days, it was $700, and for the final 10 days of the month it was $900. ($700 x 20) + ($900 x 10) = $23,000. $23,000 / 30 = $766.67 as your average daily balance that month. In this case, you'd multiply $766.67 by 0.038356% and get 0.294, and when you multiply that by 30 you end up with an estimated $8.82 per month in interest.
These are estimates, but if your interest compounds you may end up paying more interest than the APR.