How to calculate interest on a loan
For those seeking financial loans, the first hurdle on their way to qualifying for a loan is the credit score. If you have a bad credit score, you will probably be denied by the banks or other lenders. If somehow, you succeed in qualifying this step, the next thing to halt the process is the interest rates. While applying for a loan, you may meet several lenders who would be ready to help you by providing loans on reasonable terms and conditions. But the interest rates they apply might be too high for you to pay back.
Some borrowers back off at the very first step, while others start arguments after getting the loan when they realize how much would they have to pay on a certain percentage. Hence, the best way to avoid such conflicts in the later stages is to know how to calculate interest on a loan, so that you would be having an idea about the payable amount on a particular interest rate prior applying for the loan.
What Does Interest Means?Interest is quite a familiar term for everyone involved in financial and economic matters in one or the other way. Even a layman has heard the word 'interest'. But, many of us don't have an exact idea of what interest is.
Well, to make it simple, 'interest' is actually the fee you have to pay for borrowing the money. Of course, this is how the lenders (whether a bank, credit union or another money lender) earn their profit by lending money. They are not supposed to take such financial risks as a mere charitable step. Whether you are collaborating with the banking sector, or are pledging loans from any other lender, you have to pay a certain amount, other than the actual money borrowed, as interest.
Things You Should Know To Calculate InterestThere are certain terminologies which you should know before applying for a loan. All these factors play a role in finalizing the total amount you should pay at the time of return.
1. Principal AmountIt is the actual amount you are planning to borrow from a lender. Though the term may sound easy, you actually have to be careful while finalizing this amount since it provides the sole basis on which the rest of the factors relied on. At first, you should choose an amount which suffices to meet your requirements. Secondly, you need to finalize an amount that is feasible for you to pay. Plus, keep this in mind that you would be required to pay interest in addition to the actual amount. So, the more amount you select, higher will be the interest, and hence, you will be required to pay more in return.
Moreover, while finalizing your principal amount, you should consider your future engagements where you would be required to invest your money. Then see if you could be able to pay the loan returns after subtracting the amount for personal expenditures.
2. Term Of LoanThe loan term depicts the total duration in which you have to return the loan. It varies according to the amount borrowed, and the percentage of interest applied on the principal amount. The loans with shorter durations usually have low-interest rates but have high repayments. The longer the term of the loan, smaller will be the monthly repayments but with higher interest, which, in turn, causes a marked increase in the total amount to be returned to the lender. You can opt for any of these plans according to your budget and your financial needs. If you wish to pay back the borrowed amount quickly, then a short-term loan is suitable for you, as you only have to manage the higher monthly refund, without needing to worry about the interest. However, if you cannot afford to separate out a higher amount each month to return the loan, then the long-term loan may suit you. But you have to be ready to pay a much higher amount of money than you initially borrowed due to a higher interest.
3. Schedule of RepaymentYou will be offered with various payment schedules by the lender, such as every week, fortnightly, or on a monthly basis, depending upon the principal amount, loan term and the rate of interest. The loans with quick repayment schedules will benefit you as regards the total amount to be returned since they will be applying a lower interest rate. But, make sure that you can feasibly afford such quick returns from your budget.
4. The Scheduled Refund AmountDepending upon the principal amount, and the repayment schedule and the rate of interest, you will be asked to pay back a certain amount as agreed between you and the lender. A particular share of what you repay goes to the interest at first. Then the remaining amount is considered as the return of principal amount.
5. Rate Of InterestThe interest rate is the percentage of the amount you are obliged to pay as the fee for borrowing some money. This interest rate is calculated on the basis of the Annual Percentage Rate (APR) also known as the Annual Interest Rate. For instance, if the APR is 12% on your borrowed amount, it means that a 1% monthly interest rate is levied to you. Likewise, you can divide the APR accordingly to find the rate of interest for any other payment schedule, such as weekly or fortnightly.
How To Calculate Interest On A Loan?Now that you know the basic terminologies, let's move on to learn how to calculate interest on a loan. The calculation is really not complicated, and it will benefit you later if you are able to figure out the interest rate prior applying for a loan. In this way, you will have a clear idea about what you have to pay in return when you borrow a certain amount. You will hence be able to make your budget accordingly. Moreover, you will be able to decide which type of loan you should apply for, and when to apply for it.
If you do not wish to dig into the details, and just need to know the amount payable after you get a loan, you can choose to calculate this amount vi the online interest calculators. They have all the formulae preset within the codes. You just have to enter the principal amount, the rate of interest, and other details as required. But if you know the exact mathematics behind these estimations, then you can try doing all the calculations manually. Here is how you will calculate the interest on a loan.
Confused after seeing this equation? Let us elaborate the formula in a step-by-step manner.
Suppose you want to apply for a loan of $30,000, which is due to be repaid over a period of 6 years (48 months) with an Annual Interest Rate of 8.4%, here is how you shall be repaying each month.
Step#1: Calculating The Interest Rate According To The Repay ScheduleCalculate the interest rate according to your repayment timeline according to the following equation.
For instance, if the APR is 8.4%, and you have to repay every month, then divide 8.4% by 12. That means the monthly interest rate levied to you will be 0.007%.
Step#2: Calculating The Payable Interest Amount With Each InstallmentAfter you get the scheduled interest rate, multiply the figure by the principal amount to get the amount payable each month in lieu of interest. For instance, the monthly interest rate of 0.007% will now be multiplied by the principal loan of $30,000, which gives $210 as the answer.
It means you have to pay $210 in the first month in lieu of interest only.
Now as the amount of interest becomes lowered with each installment, you have to calculate the exact amount payable each time. How would you do that? Step 3 will answer it.
Step#3: Calculating The New Balance Of Loan After Every RepayNow that you started to return the loan amount, let’s calculate the new balance each month after you pay the scheduled amount. The formula applied here will be:
Principal Loan-(Repayment-Interest Amount)= New balance
By exploiting our present example here, we get a new balance of $ 29,678. Here’s how it is obtained.
It means you now have a remaining balance of $29,678 to be paid in the next 11 months. Using the same formula, you can calculate the amount payable throughout the time. The new balance will become the principal loan for the subsequent calculation. You can draw a table to have all the values readily available to you.