How to calculate loan interest

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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 if you can afford to take on new debt and the associated interest payments.

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

Interest involves all sorts 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 to borrow money.

“It’s important to remember that buying the item you want will cost more if you factor in the cost of borrowing money,” says Burns.

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

Pro tip

Before you take out a loan, do 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 depends on an interest rate, which the lender decides based on the type of loan, your credit history, and your income level, among other factors.

How to calculate interest on a loan

Before taking out any type of loan, it is important to understand the underlying calculations. This will give you an idea of ​​your monthly payments, as well as the total amount of interest you will pay over the life of the loan.

But how do we calculate it? There are many free loan calculators online that allow you to enter the loan amount, term and interest rate – information you should receive from your lender – to see your monthly payments and total interest due. .

If you’re curious, here’s how the calculations break down. We will focus on an amortized loan, which is a common type of loan that simultaneously affects principal and interest payments. This is what you will have for most auto, personal, and home loans. You can use our amortization schedule calculator or do the calculation yourself. (If you’re looking for other kinds of formulas like how to see how much your savings will grow or how much your mortgage will cost you in the long run, check out the rest of the calculators on NextAdvisor.)

If you’re going the old school route, get out a pen and paper. You will 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 this based on our earlier 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 the amount of 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 overall amount of debt you already have.

“The interest rates offered to any borrower will depend to a large extent on that borrower’s credit history. Lenders will charge higher interest rates from people with lower credit scores. The best rates are offered to those with a high credit score and a low debt-to-income ratio. The lender, after all, is taking a risk by letting you use their money,” says Glenn Downing, Certified Financial Planner and Founder of CameronDowning.

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

“A lot of these new lenders use, literally, thousands of other variables,” says Anuj Nayar, financial health manager 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 also affects interest rates. The more money you borrow, the higher the risk for the lender, which usually means a higher interest rate for you too. Nayar advises borrowers to think critically about how much money they really need and try to minimize the loan, which in turn can reduce the amount of interest paid.

How to Get the Best Interest Rates on Loans

One of the easiest ways to ensure you get the best interest rate is to shop around. Compare loan offers side by side and choose the one that suits you best.

But getting the best personal loan rates actually starts long before you 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 most important thing is to reduce your existing debt,” says Nayar. “The cheapest way to get money is to have money.”

This is 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 hire 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 also responsible for the debt, and it could undermine their credit rating if you miss payments.

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

So whether you pull out a pen and paper or use one of NextAdvisor’s online calculators, take the time to understand the true cost – interest included – behind your next loan.

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