Use This Formula to Help You Calculate Loan Interest

A photo to accompany a story about calculating loan interest Image by Getty/Illustration by Next Advisor

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Most of us don’t have tens of thousands of dollars lying around to buy a car or a house, so we turn to the classic solution: loans. But with loans comes interest.

Don’t worry about the unknown. Understanding some simple math, or using an online loan calculator, will help you determine whether you can afford to take on a new debt and the associated interest payments.  

“In order to use other people’s money, they want reassurance you will pay, and they want to be paid for the use of their money. That is interest,” said Nadine Marie Burns, president and CEO of A New Path Financial, an investment advisory firm.

Interest entails all kinds of potentially confusing concepts, like rates and amortization. Here’s a breakdown of how interest works, how to calculate it on a loan, and how to get the best interest rates.

What Is Interest?

Interest, in the simplest terms, is the price you pay for borrowing money

“It is important to remember that the purchase of the item you want will be more expensive when you factor in the cost of borrowing the money,” says Burns.

That’s because a lender won’t simply give you the amount you need. If you borrow $15,000 to purchase a car, for example, you could end up paying closer to $17,000 back to the lender once you factor in a 5% interest rate. That $2,000 is the cost of borrowing.

Pro Tip

Before you take on a loan, run the math to make sure you know how much your monthly payments will be, and how much interest you’ll end up paying by the time you’re done.

The amount of interest you’ll pay is dependent on an interest rate, something the lender decides based on the type of loan, your credit history, and income level, among other factors.

How to Calculate Interest on a Loan

Before you take out any kind of loan, it’s important to understand the math behind it. That will give you an idea of your monthly payments, as well as the total amount of interest you’ll pay over the course of the loan.

But how do you calculate it? There are lots of free loan calculators online that allow you to plug in the loan amount, term and interest rate — information you should receive from your lender — to see your monthly payments and total interest owed.

If you’re curious, here’s how the math breaks down. We’ll focus on an amortized loan, which is a common loan type that puts payments toward both principal and interest simultaneously. These are what you’ll have for most auto, personal and home loans. You can use our amortization schedule calculator, or do the math yourself.  (If you’re looking for other types of formulas like how to see how much your savings will grow or how much your mortgage will cost you in the long run, take a look at the rest of the calculators on NextAdvisor.)

If you choose the old school route, get out a pen and paper. You’re going to use this formula and solve for (A), which is your monthly payment including interest. (P) is the principal, or loan amount; (r) is the interest rate per period; and (n) is the total number of payments.

A = P {r(1+r)^n} / {(1+r)^n –1}

Let’s calculate that based on our previous example of a $15,000 car loan, with a 5% interest rate paid over 5 years of monthly payments. (P) would be $15,000; (r) would be 0.00416, or 0.05 divided by 12 months; and (n) would be 60, based on 12 payments per year for 5 years.

Then, you plug in the numbers and do the math:

15,000 {(0.00416 x 1.00416^60) / (1.00416^60 – 1)}

= 15,000 {(0.00416 x 1.282) / (1.282 – 1)}

= 15,000 (0.00533 / 0.282)

= 15,000 (0.0189)

= $283.86

So that means your monthly loan payment, including interest, would be $283.86.

Factors That Affect How Much Interest You Pay

There are a handful of important factors that have the biggest impact on your potential interest rates. You can probably guess them: credit score, debt-to-income ratio, and the overall amount of debt you already have.

“The interest rates any borrower is offered will depend to a great extent upon that borrower’s credit report. Lenders will require higher interest rates from people with weaker credit scores. The best rates are offered to those with a high credit score and low debt-income ratio. The lender, after all, is taking a risk in letting you use his money,” says Glenn Downing, a certified financial planner and founder of CameronDowning.

But these days, lenders are offering new types of loan products that can take into account lots of other aspects of your financial health.

“Many of these new lenders use, literally, thousands of other variables,” says Anuj Nayar, financial health officer at LendingClub.

His company is a prime example: They might look at your bank account balances or your monthly cash flow to try to get you a lower rate, Nayar says.

The loan amount affects interest rates, too. The more money you borrow, the higher the risk for the lender, which usually means a higher interest rate for you, too. Nayar advises that borrowers think critically about how much money they really need and try to minimize the loan, which can in turn reduce the amount of interest paid.

How to Get the Best Loan Interest Rates

One of the easiest ways to make sure you’re getting the best interest rate is to shop around. Compare loan offers side-by-side, and choose the one that works best for you.

But getting the best personal loan rates actually starts long before you go to take out a loan. It’s the hard work of improving your financial health and credit score before you need to borrow more money.

“The biggest one is to bring down your existing debt,” Nayar says. “The cheapest way to get money is to have money.” 

That’s because lenders see less risk in borrowers with less debt, and are willing to offer lower interest rates because of it.

Another option is to bring on a co-signer, someone with better credit who can vouch for you on the loan application. Keep in mind, however, that the co-signer is equally liable for the debt, and it could sap their credit score if you miss payments.

Don’t let the very idea of calculating loan interest and diving into algebraic formulas scare you. Understanding how interest works is a crucial step to making smart decisions about loans.

So whether you break out a pencil and paper, or use one of NextAdvisor’s online calculators, take the time to understand the real cost — interest included — behind your next loan.