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How Is Interest Calculated On A Loan – When you take out a loan, whether it’s a car loan, a home loan or an amount on a credit card, you will have to repay the amount you borrowed plus the interest on top of that. But what do we mean by that?
Basically, interest is a fee you pay for using someone else’s money (usually the bank’s money). This is how lenders make a profit from giving loans – after all, they’re not in it out of the goodness of their hearts.
How Is Interest Calculated On A Loan
The repayments you make on a loan will usually consist of two parts: the part that reduces your balance to pay off your loan, and the part that covers the interest on the loan.
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You will need to know a few basic facts about your loan before calculating how much interest you will pay. All of these things should be available to you for free before you take out the loan, and it’s a good idea to know all of them, even if you’re not trying to calculate interest.
This is the amount you want to borrow. But it’s not as simple as deciding how much you want – you should be focusing on how much you can realistically afford to pay back.
To calculate it, consider your budget at all levels – annually, monthly and weekly – and think about any life changes you might encounter, such as having children or moving house. also great, free resources to help you work out how much you can borrow, such as our:
How long will you repay your loan? Shorter loan terms will generally mean higher repayments, but less interest in the long run. Longer terms will reduce monthly repayments, but cost more in interest over the life of the loan.
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For example, our personal loan repayment calculator shows, on a loan of $20, 000 at 8.75% per annum. you would pay:
On many loans, you will have the option to make repayments weekly, fortnightly or monthly. Which one you choose will depend on your budgeting style.
More repayments mean less interest, due to compounding effects, so weekly repayments will save you some money. But before you commit to a weekly repayment schedule, make sure your budget can accommodate it.
When you make your repayment, it doesn’t all go towards repaying your loan, per se. A certain amount will go towards paying the interest first and then what is left goes towards your main loan. As the amount of interest you pay depends on what your principal is, to calculate ongoing interest costs, you will need to know how much you are making in repayments.
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When calculating interest on your loan, remember to use the basic annual interest rate and not the comparison rate to get accurate numbers. The comparison rate takes into account fees and charges as well as interest, so if you use it, you will get a higher amount of interest than you should.
These loans are called amortizing loans. The mathematical whistles at your bank have been calculated so you pay a certain amount every month and at the end of your loan term, you will have paid the interest and principal.
You can use an interest calculator to work out how much interest you pay in total, or, if you’d rather do it by hand, follow these steps:
1. Divide your interest rate by the number of payments you make during the year (interest rates are expressed annually). So, for example, if you make monthly payments, divide by 12.
Fixed Interest Rate (%)
2. Multiply it by your loan balance, which is your total principal amount for the first payment.
So, for example, on a personal loan of $30,000 over a period of 6 years at 8.40% per annum. and make monthly repayments:
As you have now started repaying your principal, to calculate the interest you will pay in the following months, you need to calculate your new balance first. So:
1. Less the interest you just calculated from the amount you repaid. This gives you the amount you have paid off the principal loan.
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To calculate ongoing interest payments, the easiest way is to break it down into a table. So using the example above, your calculations might look like this:
Bearing in mind that doing the calculations yourself involves minor inconsistencies due to rounding and human error, this should give you a pretty good idea of what you’re paying in interest each month.
Take out a home loan? You may have the option to choose between a principal and interest loan or an interest only loan.
As the name suggests, if you choose to take out an interest only loan, then your entire monthly payment will go towards interest. You will not save your principal, which means the amount of interest you pay will not change.
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In the example above, you would only pay $210 in interest each month, and then at the end of the 6 years, you would have a lump sum of $30,000 to pay in full.
It’s a good idea to think of using a credit card as taking out a loan. It’s money that isn’t yours, you’re paying to use it, and you better pay it back as soon as you can.
For the most part, calculating how much you pay in interest on your credit card balance works much like any other loan. The main differences are:
It’s always a good idea to pay off as much of your credit card balance as you can, as soon as you can. This way, you will avoid being hit by high interest rates.
What Is Interest?
So when you calculate your interest, remember to use the correct amount for your repayment value and add any additional purchases to your balance, and the method above should work to calculate your interest.
If all that looks like too much math to stomach, or you don’t have time to become a spreadsheet expert, you can use our handy financial calculators to do the work for you.
Our repayment calculators will tell you how much you will repay monthly, fortnightly or weekly, and give you the total interest you will wind up on your car, personal or home loan. And our credit card debt payoff calculator will show you how long it will take you to pay off credit card debt, along with how much you’ll pay in interest and fees.
The money rate reflects the market interest rate on funds that banks borrow and borrow from each other overnight. It is set by the Reserve Bank of Australia (RBA), which meets on the first Tuesday of every month (except January) to discuss any possible moves.
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But what does this have to do with commercial interest rates? Simply put, the cash rate acts as a benchmark rate for savings accounts and variable rate home loans. When the RBA raises or lowers the cash rate, banks and lenders tend to adjust their home loan and deposit interest rates shortly afterwards.
There are a number of things the RBA will consider when deciding whether to change the cash rate. Chief among them are domestic conditions, such as employment and inflation, although global financial conditions are also important.
If the economy is booming and high demand pushes prices up, the RBA may increase the cash rate to ensure inflation does not get out of control. And if the economy is weak and demand is low, the RBA could lower the cash rate to encourage spending, borrowing and investment.
Although the cash rate is one of the main things that banks will consider when setting commercial interest rates, it is not the only one. Banks will also keep an eye on overhead costs, as well as maintaining a healthy margin between the loan and deposit rates they offer.
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In general, online banks tend to offer cheaper home loan rates and more generous savings account rates than their larger counterparts, as they have fewer overhead costs to worry about. The other side of this is that larger banks tend to offer more in terms of physical branches and face-to-face services.
Fixed home loan rates and term deposit rates are not tied to the cash rate in the same way that variable rate products are. Although they appear to move in line with the cash rate, they are more so a reflection of how the economy is progressing.
It is more accurate to say that government bonds influence rates in this way. By buying government bonds with the aim of lowering medium-term fixed rates, the RBA is effectively pushing fixed mortgage and term deposit rates lower.
Whether you’re looking for somewhere worthwhile to put your savings or considering taking out a mortgage, it’s worth getting a sense of where interest rates are at the moment. If you’re not sure what’s available, our comparison pages are a good place to start.
Flat Rate (finance)
Niko Iliakis is a finance journalist specializing in home loans, property and interest rate movements. With an eye for facts and figures, Niko dives deep into topics to help readers understand key information and
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