What is loan interest?

The interest is the cost you pay to borrow money. A $20,000 personal loan can result in you paying almost $23,000 to the lender over the term of the loan. The interest is an additional $3,000

A portion of your loan repayments will go towards the principal amount. The remainder will be used to pay interest. The amount of loan interest charged by the lender depends on your credit history, income and current debt.

How to calculate loan interest

Lenders use different methods to charge interest in order to maximize their profits. Calculating loan interest can be complicated because some types of interest require more math.

Simple interest

Lenders using the simple interest method make it easy to calculate loan interest. If you have all the information, the process is straightforward. To calculate your total interest costs, you will need to know the principal amount, the interest rate, and the total time that the loan will be repaid.

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Amortizing loans

Lenders often charge interest on the basis of an amortization schedule. This category includes student loans, auto loans, and mortgages. These types of loans have fixed monthly payments. The loan is paid in equal installments. However, the way that the lender applies the payment to the loan balance changes.

Amortizing loans are typically interest-heavy. This means that less money is being paid each month towards principal loan repayments.

The table changes as you get closer to the loan repayment date. The lender will apply the majority of your monthly payment towards your principal balance, and less towards interest fees at the end of your loan.

Calculation

Here are the steps to calculate interest on an amortized mortgage loan.

Divide the interest rate by how many payments you will make in a given year. To get 0.005, divide a 6.0% interest rate by monthly payments.

Divide that amount by the remaining balance on your loan to calculate how much interest you will pay each month. 25 dollars would equal a $5,000 loan balance.

Add that interest to your fixed monthly payment and you’ll see the amount of principal you’ll pay in the first month. Your lender may have told you that your monthly fixed payment is $430.33. You will then pay $405.33 towards the principal for the first 30 days. This amount is subtracted from the outstanding balance.

Repeat the process for the next month with the new loan balance. Then, continue the process for the next month.

Factors that could affect the amount of interest you pay

There are many factors that can impact the amount of interest you pay to finance. These are the main variables that will affect how much interest you pay over the term of your loan.

The amount of the loan

How much interest you pay to a lender will depend on how much money you borrowed (your principal loan amount). The higher the amount you borrow, you will pay more interest.

Lenders take on greater risk when they make larger loans. According to Jeff Arevalo (GreenPath Financial Wellness financial expert), the lender seeks higher returns.

You’ll pay $2645.48 interest on an amortized schedule if you borrow $20,000 for five years at a 5 percent rate. The interest rate you pay over five year would rise to $3,968.22 if you kept all other loan factors constant (e.g. term, interest type, rate) and increased your loan amount by $30,000

The takeaway: Never borrow more money than you absolutely need. Calculate your actual money needs by crunching the numbers.

Interest rate

When calculating the total cost of borrowing, it is important to consider your interest rate. A lower credit score will usually mean that you will pay higher interest rates.

Let’s take the example of a 5-percent loan and compare it with a 7-percent loan. The total interest cost for a 5 percent loan is $2,645.48. The cost of interest increases to $3,761.44 if the interest rate is increased to 7 percent.

Also, you will need to determine whether your loan has a fixed or variable interest rate. Variable interest rates can cause fluctuations in your interest costs and impact your overall financing cost.

The takeaway: It might make sense to improve your credit score before you borrow money. This could increase your chances of getting a lower interest rate and paying less for your loan.

Lender term

The length of your loan term is how long a lender will allow you to pay off your debts. Your loan term for a 5-year auto loan is 60 months. On the other hand, mortgages typically have 30-year or 15-year terms.

Your interest rates can be affected by how long it takes to repay the money borrowed.

While shorter loan terms will generally result in higher monthly payments, you will also pay less interest as you reduce the repayment time. While longer loan terms might reduce your monthly payments, you will pay more interest over the long-term because you are stretching out repayments.