How To Calculate Loan Interest

A loan’s interest rate indicates how much you’ll pay on an annual basis to borrow money. It’s expressed as a percentage of the loan amount and interest costs are usually spread out over the loan’s term as part of the overall monthly payment. 

If you’re considering how much a loan might cost with different interest rates or repayment terms, knowing how to calculate loan interest on your own can help. It’s also helpful if you’re comparing loan offers or deciding whether to use a credit card instead. 

Why it’s important to understand loan interest

When you borrow money, you'll typically pay interest on the loan. The higher the interest rate, the more expensive the loan, in most cases. It’s also crucial to see how much interest you pay on loans with different repayment terms. For instance, a longer-term loan with a lower interest rate could actually cost more to repay than a shorter-term loan with a higher rate. 

“Taking a few minutes to understand how interest is calculated helps you compare offers more accurately and plan your payments with confidence,” says Sean Briscoe, Director of Products and Payments at Alliant Credit Union. Many lenders express a loan's interest rate as an annual percentage rate, or APR, which accounts for both the interest rate and any upfront fees. Comparing APRs on different loans can make it easier to understand which loan could cost you less overall. 

Methods of calculating loan interest

There are different ways a lender can calculate interest on your loan. Some loans charge simple interest, while others charge compound interest, which may accrue daily, monthly, quarterly, or annually. A loan that charges simple interest is generally lower-cost than a loan that charges compound interest at the same rate. 

In the following sections, learn how to calculate loan interest using the simple interest and compound interest methods. 

Simple interest method

Simple interest is calculated on the principal loan balance only. So, even if the amount you owe were to increase because of new interest charges, you wouldn’t be charged interest on the interest you owe. 

Where used 

Many personal loans have simple interest, as do most auto loans, student loans, and mortgages. Short-term loans, like payday loans, also commonly have simple interest. 

Compound interest method

Compound interest is calculated based on the principal amount of your loan and any interest that has been added to your balance. When your loan uses a compound interest calculation, you essentially pay interest on the interest charged, which may cause your balance to grow quickly over time. Interest may even compound daily on some debts, like credit cards.

Where used

You'll see compound interest more with revolving debts, like credit cards, rather than installment loans, like personal loans or auto loans. 

Simple interest vs. compound interest

Based on the examples above for a $5,000 five-year loan at 18%, interest costs by each method would be:

• Simple interest: $4,500
• Compound interest: $7,450

However, in both cases, no principal payments are made on the loan, which would be uncommon for an actual loan. These examples are only to demonstrate the difference between simple and compound interest.

What is amortization?

Lenders apply complex calculations to spread costs, including principal and interest, over a loan’s repayment term. This process is called amortization, and typically applies to loans that charge simple interest. It allows you to have a fixed monthly payment while paying down part of your balance and loan interest with each payment. Because lenders calculate interest on your remaining balance, interest is highest at the start of the loan, so early payments cover mostly interest instead of principal. 

“That can make it feel like the balance isn't moving much at first, but that's just how amortization works,” says Briscoe. “As time goes on, the portion going toward principal gradually increases, and you start building equity or reducing your debt faster.”

Where used 

Amortization usually occurs with installment loans that charge simple interest, such as mortgages and personal loans. If your loan is amortized, your lender may give you an amortization schedule that breaks down the amount of interest and principal each payment will cover until you pay off the loan.

Factors that impact loan interest

Several factors can influence the interest rate you get on a loan: 

• Inflation and the economy: Outside influences, like inflation and the current economy, affect interest rates. The Federal Reserve attempts to counteract inflation by raising interest rates to slow the economy (and bring down inflation) or lowering rates to boost the economy. “For the years between the financial crisis and the pandemic, inflation was very low, and borrowers benefited from very low rates,” explains Robert S. Goldberg, James F. Bender Clinical Professor of Finance at Adelphi University. “Since the pandemic, the government has struggled to control inflation, and this has led to significantly higher borrowing costs for everyone.”
• Credit score: Lenders commonly check a borrower's credit score to get insight into how responsibly they use credit. Borrowers with bad or fair credit may be riskier to a lender, so they'll typically pay a higher interest rate than they would with an excellent credit score. Use Credible's free credit-monitoring tool to check your score before applying.
• Debt-to-income ratio (DTI): DTI indicates how much of your income goes toward debt payments. Generally, lenders like to see a DTI below 36%. A low DTI can signal to lenders that you manage debts responsibly, which could lead to a lower rate. On the other hand, a high DTI adds more risk for the lender, potentially warranting a higher interest rate. To calculate DTI, divide your minimum monthly debt payments by your gross monthly income. 
• Loan length: Through the lender's lens, a longer repayment term gives more opportunities for a borrower to default. Therefore, a five-year loan term often leads to a higher interest rate than, say, a two-year loan term.
• Loan-to-value ratio (LTV): LTV measures the amount borrowed against the asset securing the loan, like a home or car. A lower LTV means a borrower is financing less of the purchase price, reducing the lender's risk and potentially offering a lower interest rate. LTV is only applicable for secured loans, like mortgages.
• Secured vs. unsecured: Different types of loans have different interest rates. For example, a mortgage usually has a much lower rate than a personal loan because it's secured by your home, so the lender has more protection if you default. 

Common mistakes when calculating loan interest

Aside from using the wrong formula to calculate the type of interest on your loan, there are a few additional factors that could affect how you calculate loan interest if you want to estimate your payments and interest costs:
 

• Missing small details in the formula: Interest formulas are often complex, and it can be easy to plug in the wrong number or make an error in the calculation. But even a small error can throw off your interest and payment estimate. Double-checking your work is always a good idea, but it can also help to use an online loan calculator that can make the calculations for you based on your loan information.
• Confusing interest rate and APR: A loan's interest rate is the amount a lender charges to finance your loan. APR includes interest and upfront fees, which can give you a better idea of your actual costs for the loan. 
• Calculating the wrong compounding frequency: Two loans might look the same number-wise, but if one compounds interest more frequently than the other despite having the same interest rate, it'll increase what you pay over time. Before borrowing, read through the loan agreement to determine how the lender calculates interest, or contact the lender for more information.