How To Calculate Interest Rate on a Loan in 4 Steps

When you take out any type of loan, lenders will earn money on it by charging interest. Interest is what it costs to borrow money. Some lenders may charge simple interest, and others charge interest at an amortized rate, where more interest is charged during the first few years of the loan.

The interest rate on a loan is charged as an annual percentage of the total loan amount. Each monthly payment includes a portion of interest and principal. Knowing how to calculate the interest rate on a loan will allow you to get a handle on how much it costs to borrow. To calculate how much you’ll pay in simple interest over the life of a loan, use this formula: Loan amount x interest rate x term of the loan = interest amount in dollars. You can also use an online calculator to calculate the interest.

Other than learning how to calculate the interest rate on a loan, it is also important to understand the factors that may influence the interest rate you receive on a loan offer. Some of these factors are the loan’s term to maturity, the loan amount, and of course, your credit profile and FICO score. Read on to learn more about calculating interest and what influences the amount of interest you pay on most loans that you might find available today.

How To Calculate Interest Rate on a Loan

Follow these four steps to calculate the interest rate on any loan. 

1. Gather Necessary Loan Information

To calculate the interest on a loan, you’ll need some basic information, such as the loan amount, interest rate, and loan term. Typically, you can find this information in the Promissory Note section of your loan agreement documents. If you don’t have the documents handy, you can always contact your financial institution or credit union and request that they send you a copy.

Loan Amount

Your loan amount is the original total or principal you borrowed from the lender, which doesn't include any interest. Let’s take the example of a mortgage. If you purchase a $450,000 home and put down $50,000 as a down payment, it means that your loan amount is $400,000.

You’ll need to pay back that amount plus interest charges over the length of the loan term. If your interest rate is 7.08% and the term is 30 years, you can expect to pay $565,784 in interest charges over the entire 30 years of the loan term. 

Interest Rate

You’ll usually see the interest rate expressed as an annual percentage rate (APR) on your loan agreement. This is not to be confused with the annual percentage yield (APY) related to the interest rates you earn and receive from your savings and investments.

Loan interest rates may be fixed or variable. With a fixed interest rate, the rate will remain constant throughout the entire loan term. A variable interest rate can fluctuate over the loan term based on a reference rate or index, such as the Fed Funds rate or LIBOR.

Loan Term

The loan term will also be specified in your loan agreement as the duration of time within which you have to repay your loan in full. Loan terms can vary depending on the amount you borrow and the nature of the loan. Loans can be long-term or short-term. Some of the most common loans you may know have a fixed loan term, including mortgages, auto loans, personal loans, and student loans.  

2. Determine the Type of Interest Rate

Interest comes in several different forms. For a borrower, it's important to know the difference between these interest rates so they can determine if a loan product is right for them. The two main types of loan interest rates are fixed rates and variable rates.

Fixed Interest Rate

When a loan has a fixed interest rate, the interest rate will remain the same throughout the loan term. This means that your borrowing cost will remain constant even with economic and financial market fluctuations that may send interest rates on the same kind of loan up or down at any given time. When you take out an installment loan such as a student loan, car loan, mortgage, or personal loan, you'll have standardized monthly payments with a fixed rate.

For homeowners, opting for a fixed-rate mortgage loan allows them to budget for their monthly payments over the long term. It's an attractive option for many because it protects them against the possibility of rising interest rates and the increased mortgage payments that come along with them.  

Variable Interest Rate

A variable interest rate adjusts over the loan term in response to interest rate fluctuations. Many consumer loans with a fixed interest rate are also available with a variable interest rate, such as mortgages and student loans. Personal loans and auto loans are typically available with fixed rates, though some lenders may offer an option for variable rates.

Variable rate loans generally tend to be lower at the beginning of the loan term than fixed rates do because they are riskier for borrowers, in the sense that when interest rates rise, the cost of borrowing can increase greatly. If you choose variable rates, it's important to be aware of the potential for higher loan payments whenever increases in interest rates re-set the interest portion of your loan payment amount. 

Variable rates are a good choice for you if you plan to pay off your loan quickly and can afford to take the risk. Variable-rate loans are also a good choice when the general interest rate is high and expected to fall during the loan term.

3. Calculate Loan Interest Rate

In most cases, loans are advertised with an interest rate, which can be variable or fixed. In some cases, loans may be structured in such a way that a fixed amount of money is loaned to you at the beginning of the term, and a fixed amount will be due at the end of the loan term.

Learning how to calculate a loan interest rate allows you to compare it with other interest-based loan products, including the following:

Annual Interest Rate

The annual interest rate is the interest rate that's applied to your loan over a period of one year. There are two ways to calculate your annual interest rate, manually and with an interest calculator.

If you use a calculator, input the loan amount, loan term, and your monthly payment to get your annual interest rate. To calculate this manually, follow these steps: 

Divide the amount of additional payment you'll make by the amount loaned to you. For example, if you take a loan of $1,000 and are required to repay $1,300 in one year, divide $300/$1,000. This means that your annual interest rate is 30% each year. This is also referred to as the simple interest rate.  

If the length of the loan term is longer than one year, then divide this initial interest rate you’ve calculated by the loan term in years.  So for our example above, if the loan term was for 4 years, the annual interest rate would be (30% / 4 years) = 7.50%.

Monthly Interest Rate

Once you know the annual interest rate of a loan, learning how to calculate monthly interest is fairly simple. Knowing your monthly costs will allow you to know exactly how much your loan costs each month.

To calculate your monthly interest rate, divide your annual rate by 12. In the example above, the annual interest rate was 30%. Divide 30% by the loan term in months (in this case, 12 months. Doing so will give you: (30% / 12) = 2.5%. This means that your monthly interest rate in this example is 2.5%.

4. Calculate Your Interest Payment

If you want to calculate the dollar amount of the interest you'll be paying for a loan, you will first have to learn if the lender is using simple interest or amortized interest.

Simple Interest

Calculating the interest amount in dollars for a simple interest loan is easy. Simply use this formula: Loan amount x annual interest rate x term of the loan in years = interest amount in dollars.

For example, if you take out a $10,000 loan for five years and the interest rate is 5%, the formula will be $10,000 x 0.05 x 5 = $2,500. This means you will be paying $2,500 in interest charges over the term of your loan.

Amortized Interest

Many lenders charge amortized interest, including auto loans and mortgages. The monthly payments on these types of loans remain fixed, but the interest charged each month changes over time. With amortization, the payments in the first few years are interest-heavy, meaning that a smaller portion of each payment will go toward the principal, and the majority of your monthly payment will go toward paying interest. 

As time passes, this situation reverses so that by the time the loan is close to being paid off, a small portion of your monthly payments will be applied toward interest, and most of each payment will go toward reducing your principal balance.

Here's how to calculate your interest amount for an amortized loan:

• Divide the interest rate by the number of payments you must make in a year. For example, if your interest rate is 5% and you'll be making monthly payments, divide 0.05 by 12 to get the quotient value of 0.004.
• Multiply that quotient of 0.004 by the current loan balance to figure out how much you’ll be paying in interest charges in that month. For example, if your principal amount at the beginning of the month is $6,000, the interest for that month will be $6,000 X 0.004 = $24.
• Repeat this process with the remaining loan balance each month, for the remaining loan term in months, to get your total amortized interest paid over the entire loan term.

Factors That Affect Loan Interest Rates

Several factors can impact how much interest you'll pay when you borrow funds. Here are some of the main variables that may impact the amount of interest you pay over the life of the loan.

Credit Score

Your credit score will play a major role in determining the interest rate you qualify for when you apply for a loan. Having bad credit generally means your lender will require that you pay a higher interest rate because they may consider you a higher-risk borrower based on your recent history of making payments on other loans and debt obligations.

Borrowing funds at a higher interest rate means you'll pay more money in interest over the term of the loan. If you have a fair or lower credit score, credit repair may be a smart option before you borrow money. This will make it easier for you to improve your overall credit profile, secure better repayment terms, and pay less interest.

Loan Term

The loan term is the time a lender gives you to repay the loan. For example, if you get a personal loan of $10,000 for five years, your loan term will be 60 months. Personal loans typically have a shorter loan term of 2-5 years, while mortgages have a longer term of 10-30 years.

The amount of time it takes you to pay off the money you borrow can also impact interest costs. Shorter terms generally have higher loan payments each month, but the total amount you'll pay towards interest over the life of the loan will be much lower because interest will have a chance to accrue on the loan balance over much less time.

Longer terms can provide you with much lower monthly payments, but the total interest paid will be higher over time because you'll be stretching the loan repayment out, and interest on your loan balance more time to accrue (and be charged to your outstanding loan balance) over a longer time period. Review the numbers carefully to decide how much you can afford every month. Find the right balance between affordability and keeping interest charges to a minimum.  

Loan Type

The type of loan you borrow can also impact the interest rate. For example, because they are secured by the real estate property that is purchased, using the funds lent through them, mortgages typically have the lowest interest rate, ranging from 3% to 8%, depending on the creditworthiness of the borrower and the economic climate.

Unlike mortgages, unsecured debts do not require any collateral. These loans and credit cards typically have a higher interest rate because they are riskier for creditors, in that there is no collateral that can be used to recover the funds lent in the event the borrower defaults. The average personal loan interest rate in the U.S. is 10.96%, but it can range anywhere from 6.70% to 35.99%.

Know How Much Interest You’re Paying 

Knowing how to calculate the interest rate on a loan is important so you’ll know exactly how much you’ll pay in interest charges. Ask your lender if the interest rate they charge is based on a simple interest or an amortization schedule, and use the right online loan calculator or manual formula to calculate the numbers. Only borrow as much as you need and for the shortest possible loan term to reduce your total borrowing costs each time you need to finance a purchase or pay down other existing debt.

If you've already borrowed a lot of funds with high interest rates and are finding it challenging to pay them off, debt relief can help. TurboDebt can help you manage your debt through consultation, planning, and debt relief services. 

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