How To Calculate Interest Rate on a Loan: A Simple Guide
11 MIN READ
Published June 27, 2023 | Updated December 13, 2023
When you take out any type of loan, lenders will earn money on it by charging interest. Interest is what it costs to borrow money. Some lenders may charge simple interest, and others charge amortized rate, where more interest is charged during the first few years of the loan.
The interest rate on a loan is charged as an annual percentage of the total loan amount. Each monthly payment includes a portion of interest and principal. Knowing how to calculate the interest rate on a loan will allow you to get a handle on how much it costs to borrow. To calculate how much you’ll pay in simple interest, use this formula: Loan amount x interest rate x term of the loan = interest amount. You can also use an online calculator to calculate the interest.
Other than learning how to calculate the interest rate on a loan, it is also important to understand the factors that may influence the interest rate you receive on a loan offer. Some of these factors are loan terms, loan amount, and credit score. Read on to learn more about calculating interest and what influences the amount you pay.
Gather Necessary Loan Information
To calculate the interest on a loan, you’ll need some basic information, such as the loan amount, interest rate, and loan term. You can find this information in your loan agreement documents. If you don’t have the documents handy, you can always contact your financial institution or credit union to send you a copy.
Your loan amount is the original total or principal you borrowed from the lender, which doesn't include any interest. Let’s take an example of a mortgage. If you purchase a $450,000 home and put down $50,000 as a down payment, it means that your loan amount is $400,000.
You’ll need to pay back that amount plus interest charges over the length of the loan term. If your interest rate is 7.08% and the term is 30 years, you can expect to pay $565,784 in interest charges over 30 years.
You’ll usually see the interest rate expressed as an annual percentage rate (APR) on your loan agreement. This is not to be confused with APY related to interest rates.
Loan interest rates may be fixed or variable. With a fixed interest rate, the rate will remain constant throughout the loan term. With a variable interest rate, the rate can fluctuate over the loan term based on a reference rate.
The loan term will also be specified in your loan agreement as the duration of time within which you have to repay your loan. Loan terms can vary depending on the amount you borrow and the nature of the loan. Loans can be long-term or short-term. Some of the most common loans you may know have a fixed loan term, including mortgages, auto loans, personal loans, and student loans.
Determine the Type of Interest Rate
Interest comes in several different forms. For a borrower, it's important to know the difference between these interest rates so they can determine if a loan product is right for them. The two main types of loan interest rates are fixed rates and variable rates.
Fixed Interest Rate
When a loan has a fixed interest rate, the interest rate will remain the same throughout the loan term. This means that your cost of borrowing will remain constant even with market fluctuations. When you take out an installment loan such as a student loan, car loan, mortgage, or personal loan, you'll have standardized monthly payments with a fixed rate.
For homeowners, opting for a fixed-rate mortgage allows them to budget for their monthly payments. It's an attractive option for many because it protects them against the possibility of rising interest rates and increased mortgage debt.
Variable Interest Rate
A variable interest rate adjusts over the loan term in response to market fluctuations. Many consumer loans with a fixed interest rate are also available with a variable interest rate, such as mortgages and student loans. Personal loans and auto loans are typically available with fixed rates, though some lenders may offer an option for variable rates.
Variable-rate loans generally tend to be lower than fixed rates because they are riskier for borrowers. When interest rates rise, the cost of borrowing can increase greatly. If you choose variable rates, it's important to be aware of the potential for higher loan costs. Variable rates are a good choice for you if you plan to pay off your loan quickly and can afford to take the risk.
Calculating Loan Interest Rate
In most cases, loans are advertised with an interest rate, which can be variable or fixed. In some cases, loans may be structured in such a way that a fixed amount is loaned to you at the beginning of the term, and a fixed amount will be due at the end of the loan term.
Debt expert and CEO of Greenbacks Consulting, Teresa Dodson, encourages borrowers to learn as much as they can about what they're paying. “Always understand your interest rate and other fees associated with your loan and/or credit cards." She advises. "Even a point matters!”
Learning how to calculate a loan interest rate allows you to compare it with interest-based structures, including the following:
Annual Interest Rate
The annual interest rate is the interest rate that's applied to your loan over a period of one year. There are two ways to calculate your annual interest rate, manually and with an interest calculator.
If you use a calculator, input the loan amount, loan term, and your monthly payment to get your annual interest rate. To calculate this manually, follow these steps:
Divide the amount of additional payment you'll make by the amount loaned to you. For example, if you take a loan of $1,000 and are required to repay $1,300 in one year, divide $300/$1,000. This means that your annual interest rate is 30% each year. This is also referred to as the simple interest rate.
Monthly Interest Rate
Once you know the annual interest rate of a loan, learning how to calculate monthly interest is fairly simple. Knowing your monthly costs will allow you to know exactly how much your loan costs each month.
To calculate your monthly interest rate, divide your annual rate by 12. For example, in the example above, the annual interest rate was 30%. Divide 30 by the loan term of 12. 30/12 = 2.5%. This means that your monthly interest rate in this example is 2.5%.
If you want to calculate the dollar amount of the interest you'll be paying for a loan, you will first have to learn if the lender is using simple interest or amortized interest.
Calculating the interest amount for a simple interest loan is easy using this formula: Loan amount x interest rate x term of the loan = interest amount.
For example, if you take out a $10,000 loan for five years and the interest rate is 5%, the formula will be $10,000 x 0.05 x 5 = $2,500. This means you will be paying $2,500 in interest charges over the term of your loan.
Many lenders charge amortized interest, including auto loans and mortgages. The monthly payments remain fixed, but the interest charged each month changes over time. With amortization, the payments in the first few years are interest heavy. A smaller portion will go toward the principal. As time passes, a smaller portion of your monthly payments will be applied toward interest and more toward your principal balance.
Here's how to calculate your interest amount for an amortized loan:
- Divide the interest rate by the number of payments in a year. For example, if your interest rate is 5% and you'll be making monthly payments, divide 0.05 by 12 to get 0.004.
- Multiply that by the remaining loan balance to figure out how much you’ll be paying in interest charges in the first month. For example, if your principal amount is $6,000, the interest for that month will be $6,000 X 0.004 = $24.
- Repeat this process with the remaining loan balance each month to get your amortized interest.
Factors That Affect Loan Interest Rates
Several factors can impact how much interest you'll pay when you borrow funds. Here are some of the main variables that may impact the amount of interest you pay over the life of the loan.
Your credit score will play a major role in determining the interest rate you qualify for when you apply for a loan. Having bad credit generally means you qualify for a higher interest rate because lenders may consider you a higher-risk borrower.
Borrowing funds at a higher interest rate means you'll pay more money over the term of the loan. If you have a fair or lower credit score, credit repair may be a smart option before you borrow money. This will make it easier for you to secure better repayment terms and pay less interest.
The loan term is the time a lender gives you to repay the loan. For example, if you get a personal loan of $10,000 for five years, your loan term will be 60 months. Personal loans typically have a shorter loan term, while mortgages have a longer term.
The amount of time it takes you to pay off the money you borrow can also impact interest costs. Shorter terms generally have higher loan payments each month, but the total amount you'll pay towards interest over the life of the loan will be much lower.
Longer terms can provide you with much lower monthly payments, but the total interest paid will be higher over time because you'll be stretching the loan repayment out. Review the numbers carefully to decide how much you can afford every month. Find the right balance between affordability and interest charges.
The type of loan you borrow can also impact the interest rate. For example, mortgages typically have the lowest interest rate, ranging from 3% to 8%, depending on the creditworthiness of the borrower and the economic climate.
Unlike mortgages, unsecured debts do not require any collateral. These loans and credit cards typically have a higher interest rate because they are riskier for creditors. The average personal loan interest rate in the U.S. is 10.96%, but it can range anywhere from 6.70% to 35.99%.
Know How Much You’re Paying in Interest By Calculating Interest Rates
Knowing how to calculate interest rate on a loan is important so you’ll know exactly how much you’ll pay in interest charges. Ask your lender if the interest rate they charge is based on a simple interest or amortization schedule, and use the right online loan calculator or manual formula to calculate the numbers. Only borrow as much as you need and for the shortest possible loan term to reduce your borrowing costs.
If you've already borrowed a lot of funds with high-interest rates and are finding it challenging to pay them off, debt relief can help. TurboDebt can help you manage your debt through consultation, planning, and debt relief services. Our debt professionals can help you find the right debt relief option based on your financial situation. Connect with us today for a free consultation, and read our reviews to see how our debt relief services have helped thousands of clients!