How is loan interest calculated?
Anytime you borrow money, whether it’s from a bank or individual lender, and whether it’s for a mortgage, a title loan or a personal or payday loan, you can expect to pay-back the amount you’ve borrowed, plus interest.
The interest rate is the amount a lender charges a borrower and is a percentage of the principal—the amount loaned.
The interest rate on a loan is typically noted on an annual basis known as the annual percentage rate (APR).
So, what we’re trying to help you get a better understanding of, is how exactly a lender will calculate how much interest you’ll owe when repaying your loan?
Compound or simple interest
Simple interest
Most mortgages use simple interest. However, some loans use compound interest, which is applied to the principal but also to the accumulated interest of previous periods.
So, with simple interest, if you take out a $20,000 personal loan, you may wind up paying the lender a total of almost $22,000 over the next year. That extra $2,000 is the interest, and the rate here is 10%.
Compound interest
Some lenders prefer the compound interest method, which means that the borrower pays even more in interest. Compound interest is applied to the principal but also on the accumulated interest of previous periods.
The interest owed when compounding is higher than the interest owed using the simple interest method. The interest is charged monthly on the principal including accrued interest from the previous months.
Add-on interest
The add-on interest method is more simple than compound interest mathematically. Here, the interest is calculated up front, added to the principal, and the total divided by the number of payments (months).
Factors that affect your interest rate
Generally speaking, a borrower that is considered low risk by the lender will have a lower interest rate. A loan that is considered high risk will have a higher interest rate.
Income
Lenders want to be certain you have the means to make your monthly loan payment. If you have inconsistent income, it could result in a higher APR.
Debt-to-income ratio
Most lenders will calculate the amount of your monthly income that’s currently going toward debt payments. This amount represents your debt-to-income ratio and helps clarify your ability to repay your loan.
Loan size
Since your interest rate is expressed as a percentage of your loan amount, you’ll pay more with a larger loan.
Repayment term
Opting for a shorter repayment term will result in a higher monthly payment, but it can help reduce your total interest over the long term.
