How To Calculate Interest On A Loan: A Complete Guide

Charging interest is one of the primary ways that lenders make money. For borrowers, calculating how much they’ll pay in interest can help them choose a lender, decide on their preferred loan terms and budget appropriately.

Let’s walk through how to calculate interest on a loan, regardless of the type of interest your lender charges. We’ll also provide tips for getting the best possible interest rate and later answer some frequently asked questions pertaining to the subject of how to calculate loan interest.

What Type Of Interest Does Your Loan Have?

Lenders typically charge interest in one of two ways: simple interest or amortizing interest. The loan type usually dictates which type of interest you’ll be charged, although some loans can charge either type.

An important caveat is that we’re discussing fixed-rate loans here. If your loan has a variable interest rate, matters get much more complicated.

Simple Interest

You’re more likely to encounter simple interest with a short-term loan. The amount of interest you’ll pay is calculated based on your original loan balance, your interest rate and the length of your repayment period. A fixed amount of each payment you make goes toward the principal loan amount borrowed and also toward the interest you owe. Those amounts don’t change as you make payments.

For example, if $20 on your first payment goes to interest, $20 of your last payment would also go toward interest.

Some lenders use the term “simple interest” solely to differentiate it from compound interest. (We’ll talk about compounding interest in the next section.) Here, we’re using it to describe both how the interest is calculated and how the loan is repaid. Not only is simple interest not compounding, but the interest portion of your payment is consistent as you repay the loan.

Amortizing Interest

With amortizing interest, the amount of your payment that goes toward interest will change over time. To be clear, this happens even with a fixed interest rate. Your interest rate doesn’t change, but the amount of each payment that goes toward your interest does.

Amortizing interest is always structured so that you pay more in interest early in the loan repayment process, when the balance is the highest. As the balance decreases, more and more of your payment goes to the principal balance and less goes to interest because you’re paying interest on a smaller remaining principal amount. (We’ll demonstrate this with an amortization schedule later.)

Some amortizing loans use compound interest. This means that interest is calculated on the principal loan amount and on your accumulated interest. Interest will accrue on your balance based on the compounding schedule. This can be daily, weekly, monthly, semiannually or annually.

Lenders are much more likely to use amortizing interest than simple interest, but it’s always worth confirming which is going to be in effect – especially with a short-term loan.

Common Loans And Their Typical Interest Types

To give you an idea of which loans typically use which type of interest, here’s a table breaking it all down.

All federal student loans use simple interest, but that’s not always the case with private student loans. Mortgages almost always use amortizing interest, but simple-interest mortgages do exist.

Although most lenders use amortizing interest, you should never just assume this to be so in your situation. Instead, check with your lender to verify which type of interest they use. Rocket Loans uses amortizing interest.

How To Calculate Simple Interest On A Loan

Loan amount multiplied by interest rate multiplied by years in loan term equals total interest. (Since the interest rate is a percentage, that variable will be a decimal.)

Suppose you want to take out a $10,000 personal loan at a 15% interest rate with a 2-year repayment term.

Your calculation would look like this: $10,000 x 0.15 x 2 = $3,000.

To see your monthly simple interest payment, just divide your total interest by the months in the repayment term.

In this example, that would be $3,000 / 24 = $125.

You would pay $125 in interest on your first and your last payment.

How To Calculate Amortizing Interest On A Loan

Due to your fixed payment being allocated differently over time, calculating amortizing interest is more complicated than calculating simple interest. The easiest way to calculate is to use our loan calculator, which will show the complete amortization schedule.

If you prefer to do it yourself, here are the steps:

• Interest rate / number of payments you’ll make in a year = Y (The value will always be a small decimal)
• Y x remaining loan balance = X (How much you’ll pay in interest that month)
• Monthly payment - X = How much of that payment will go to the principal

Let’s go through the steps again, this time with numbers. For this example, let’s say you owe $7,000 on your loan with an 8% fixed interest rate. Your monthly payment is $417.50.

• 08 / 12 = 0.00667
• 00667 x $7,000 = $46.69
• $417.50 - $46.69 = $370.81

Out of your $417.50 monthly payment, $370.81 will go toward the principal and $46.69 will go to interest.

One downside of calculating amortizing interest by hand is that you’ll need to redo the calculation each month as the remaining loan balance decreases.

Remember, interest is just one piece of your monthly payment on a loan. Make sure you understand how all the pieces fit together.

Amortization Schedule

Your lender should be able to provide you with an amortization schedule. This is a table showing exactly how your payments will be distributed each month over the life of the loan.

Below is an example. This is for a $10,000 personal loan that has a 15% interest rate and is on a 2-year repayment term.

Tips For Getting The Best Possible Interest Rate

The lower your interest rate is to begin with, the less interest you’ll pay over the life of the loan – regardless of how it’s calculated. Here are some tips to help you find the best possible rate:

• Work on improving your credit score: It might be worth taking steps to improve your credit score before applying for a loan. The higher your credit score, the better the loan terms a lender can offer you.
• Lower your debt-to-income ratio (DTI): Your DTI is another critical factor that lenders consider. If you take the time to lower your DTI and improve your credit before shopping around, you might be shocked by how much you can save in interest – especially over the entire loan term.
• Save up for a bigger down payment: A down payment isn’t required for all loan types, but you’re always better off in the long run if you can put down more money – or at least some money – upfront. First, you’ll be borrowing less money overall. Second, lenders can adjust your interest rate based on how much you put down, and they might give you a better deal.
• Shop around for lenders: Not all lenders price their loans the same, so it’s worth taking the time to talk with more than one lender. Be to look at the annual percentage rate (APR) in addition to just the interest rates you see.
• Consider a shorter repayment term: Your monthly payment will be more, but you’ll pay less in interest. This will save you money over the life of the loan.

FAQs: Calculating Interest On A Loan

Since there are many nuances to consider when discussing interest on loans, we’ve put together a FAQs section to help.

Is the method for calculating interest different for each type of loan?

No, it isn’t. For example, an amortization schedule for a car loan with compounding interest would work the same way as an amortization schedule for a mortgage. The number values would obviously differ, but the formulas are the same.

However, if you change the interest type, it’ll be calculated differently – even for the same loan type. For example, a personal loan that uses simple interest will be calculated differently than a personal loan with amortizing interest.

How do I calculate interest on a loan with a variable interest rate?

The short answer is that you can’t forecast how rates will change over time, so it’s impossible to accurately calculate interest on a loan with a variable interest rate. You can make predictions by inputting different interest rate values for different time periods, but you’re giving yourself ballpark estimates versus hard data points.

Predictability is one of the biggest advantages of fixed-rate loans over variable interest rate loans.

Can I deduct loan interest from my taxes?

It depends on the type of loan, but it’s possible. Interest paid on student loans and mortgages is frequently tax-deductible. Unfortunately, the interest on personal loans is not tax-deductible.

Final Thoughts

Calculating interest you’ll pay is important, but that’s not all that goes into getting a loan. Be sure to shop around before committing to a lender, and even once you’ve been approved, take the time to ask your lender any questions you have before signing the paperwork. Once the funds are disbursed, you’re on the hook for repaying them.

If you’re ready to take out a personal loan, get prequalified with Rocket Loans^SM. You’ll be able to get a feel for the size of your monthly payment as well as how much you’ll pay in interest each month and over the full repayment term.