A Simple Guide on How to Calculate Interest on a Loan

When you borrow money, being charged interest is par for the course.

But do you know how it’s calculated?

Understanding how interest works and how it applies to your loan can be really valuable when it comes to understanding how to pay off your loan more quickly.

What is an interest?

Interest is the amount that a lender charges people for borrowing money from them.

The interest rate is the percentage of the loan amount that is charged – it is almost always described in annual terms (p.a.).

An interest rate of 5 percent means you pay 5 percent of the amount owing each year.

Understanding how interest rates work can help you make informed decisions when you borrow money.

Generally, lenders charge higher rates of interest when lending is considered more risky. An unsecured personal loan, for example, often has a higher interest rate than a car loan where the vehicle is held as security. That’s because with the car loan, the lender can sell the car if the borrower doesn’t repay the loan as agreed.

What is amortisation?

Amortisation refers to the payment structure that keeps your payments equal over time. At the beginning of the loan, most of the scheduled payment is interest, with just a bit of principal repaid. But as you go along, more of the payment reduces the principal and less pays the interest.

This is why it can sometimes seem like you’re not making a lot of progress on repaying a loan at the beginning, but then the pace picks up over time.

How is interest calculated?

Most lenders calculate an interest charge daily, then roll that into a fortnightly or monthly payment.

It often works like this: The lender multiplies your interest rate as a percentage by the amount owing on the loan at the end of each day. That is divided by 365 to get the amount owed for that day. Then, this interest is added to the loan monthly. Your repayment should clear the interest and a bit of the principal owing each time.

Say, for example, you owe $20,000. Multiplying that by 0.1 to represent an interest rate of 10 percent and dividing by 365 gives a daily charge of $5, or $150 over 30 days.

What can impact the interest payable on a loan?

• Loan amount: The total interest you pay will depend on the amount you borrow because it’s a percentage of the amount owing.

• Loan term: The longer you’re repaying the loan, generally, the more interest you will pay because there is more time over which it can accrue, and it’s taking a longer time to reduce the loan balance (which is what the interest amount is calculated on).

• Interest rate: The higher your interest rate, the more interest you’ll pay, assuming all else is equal. However, a higher interest rate and a shorter term can sometimes be cheaper than a lower rate and a longer term.

• Number of days in a month: If interest is being accrued daily, on months when there are more days in the month, there can be slightly more interest to pay.

Save on interest with extra payments

When you are repaying a debt, any extra payments you make will usually go to reducing the principal owing.

That means you could reduce your future interest bill because the debt you are paying interest on is no longer as high.

In that example of a $20,000 loan with 10 percent interest, you’d pay $61 a week over 10 years and pay $11,657 in interest. Increasing it to $100 would clear it in about half the time and save you 61 months of repayments. You’d only pay $5,270 on interest.  Be sure to check whether early repayment of your loans will attract any additional fees. Sometimes, these can reduce the savings that can be made and might mean there are restrictions on how often additional payments can be made. If you have a loan through better finance™️, we can talk to you about your options.

You can check out the better finance™️ blog on how to repay a loan faster for ideas to help.

Conclusion

Understanding how interest works can be important when it comes to managing your debt and paying off your loan more quickly. If you have any questions about loans, debt repayment or borrowing money more generally, the better finance™️ team is here to help.

Disclaimer: Please note that the content provided in this article is intended as an overview and as general information only. While care is taken to ensure accuracy and reliability, the information provided is subject to continuous change and may not reflect current developments or address your situation. Before making any decisions based on the information provided in this article, please use your discretion, and seek independent guidance.