How to Calculate Interest on a Loan

3rd July 2018

By Kurt Wood

When you’re looking into loan options, one of the major factors that might affect the lender and type of loan you choose is the interest rate. Many borrowers look for low-interest loans because those rates will determine how much extra you repay your lender on top of what you’ve already borrowed. Think of this as an admin fee you pay to your lender as payment for borrowing their money. This can have a massive impact on your monthly repayments when you’re repaying a personal loan, so how do you calculate the interest you’re paying?

How is loan interest calculated?

Every loan carries an annual percentage rate (APR). This is the annual rate of interest that is charged for borrowing that loan, expressed as a percentage when compared to the loan amount.

There are a number of factors that determine the level of interest you might pay on a loan. These might be affected by the economy as a whole, your bank, or by your own personal circumstances. So, what are these factors and how do they affect how your loan interest is calculated?

How much you’re borrowing

The amount of money you want to borrow is known as the principal amount. This is the loan amount without interest added. Generally, the higher the amount you’re borrowing, the lower the interest rate will be overall, meaning you could actually end up paying less per month with a higher principal loan amount. You should, however, always confer with your lender or an independent advice service to make sure you’re borrowing the right amount for your circumstances.

How long you want to borrow

Just as a higher principal loan amount can offer lower interest rates, so too can choosing a shorter repayment period. Interest rates are generally higher over longer periods because changes in the financial market over longer periods of time could mean your bank actually ends up losing money on your loan in the long run, compared to a shorter period when they can be more confident of what’s going to happen.

The base rate of interest

One of the things largely out of your control is the base rate of interest. This is the rate of interest set by the Bank of England, which is generally the rate which banks use to borrow from each other. This base rate can affect the interest rates on personal loans imposed by banks, which in turn can impact you if you choose a variable rate loan rather than one with a fixed rate. While a variable rate will mean you benefit from lower interest rates when the base rate is lower, if you don’t have much room for manoeuvre in your finances, it’s probably best to stick to a fixed rate.

Working it Out Yourself

If you sign up for a personal loan with a monthly repayment schedule, your lender will generally work out a standard monthly repayment amount which will be split between paying off your principal loan and the overall interest. This is known as ‘amortising’ a loan. You can work out your monthly repayments by doing the following:

Let’s assume you’re borrowing £15,000 over 5 years at 3.4% APR.

Take your APR and change it to a decimal, so 3.4% becomes 0.034.

Divide that number by the number of repayments you’ll make over the course of a year (no matter how long your schedule is) e.g. If you pay once a month, that’s 12.

Multiply your total by the principal loan amount you’re borrowing (in this case £15,000) to learn your first month’s interest repayment.

Example: (0.034/12) x 15,000 = £42.50

This means that if you want to know how much of your original loan you’ve repaid, remember that part of your repayment goes towards the loan’s interest and the rest goes towards the principal amount you borrowed.

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