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How to calculate loan interest

What will a personal loan cost you?

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Written by Rachel Morey
Edited by Cassidy McCants

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    calculating interest

    Calculating the interest rate on a personal loan can be difficult. Most lenders use simple interest rather than compound interest, though, which makes the job a little easier.

    To calculate how much you'll pay in simple interest, take the principal (P) times the APR (R) times the time period in years (T), then divide that number by 100. However, many online lenders provide calculators that can do the math for you.

    How to calculate interest on a loan

    Lenders use various methods to calculate interest — some of which are much more complicated than others. However, most lenders use the simple interest method.

    To calculate simple interest on a loan, take the principal (P) times the interest rate (R) times the loan term in years (T), then divide the total by 100. To use this formula, make sure you’re expressing your interest rate as a percentage, not a decimal (i.e., a rate of 4% would go into the formula as 4, not 0.04).

    Simple interest = principal (P) x interest rate (R) x loan term in
    years (T) / 100

    Many loans, including mortgages, auto loans and student loans, are amortized, which means each of your monthly payments includes a percentage of the total outstanding principal and interest on the loan. Your amortization schedule shows how much of each payment goes to interest and how much goes to the principal.

    In the first months of your loan repayment, your payments are interest-heavy. As time passes, the amount of your monthly payment that goes to interest decreases and the amount of your monthly payment that goes to principal increases.

    It can help to use a loan calculator to better understand how your interest rate affects your monthly payment and the total amount of interest you'll pay over the life of the loan.

    What is loan interest?

    When you take out a loan, you have to pay back both the principal and the interest, which is one of the main ways lenders make a profit. You can think of interest as the amount of money the lender charges for access to the loan funds.

    The interest rate is a percentage of the total loan amount. Each of your monthly payments goes towards a portion of the principal and interest (the ratios will change throughout the course of an amortized loan).

    Loan interest vs. annual percentage rate

    Usually, the interest rate a lender quotes is actually the annual percentage rate (APR), which is a combination of interest, fees (like origination fees) and other costs. Your APR is a percentage of your loan principal (the total amount you take out) that you pay each year to borrow that money.

    Functionally, your APR might be the only number you care about, so be aware that there is a difference between it and your actual interest rate. To calculate how much you'll pay using the APR, you can use the same formula but substitute your APR for the interest rate.

    How are interest rates determined?

    Each lender sets interest rates based on market conditions, competitors' rates and the borrower’s financial situation. The reason lenders look closely at your credit history, credit score, income and other debts is to determine how much of a risk you pose.

    Borrowers with bad credit may be more likely to default on the loan, so lenders do what they can to make sure they still profit off the loan. A higher interest rate makes a risky loan safer for the lender’s bottom line, and the risk is even greater when there’s no collateral to repossess should the lender default.

    For example, an auto loan is a secured loan that uses the car as collateral. That means the lender can legally repossess the vehicle and sell it if you default on the loan. An unsecured loan, on the other hand, doesn't require collateral. Since unsecured loans are riskier for lenders, they usually have higher interest rates. In either case, borrowers with excellent credit tend to get the lowest rates because lenders find them less dangerous.

    How to get the best interest rates

    A lower interest rate can mean big savings as you repay a loan. Here are some tips to get a great interest rate on a loan.

    1. Improve your credit score.

    Working to improve your credit score may help you secure a loan with a lower interest rate, especially if your credit score is in the mid-600s or lower. Fixing your credit takes time, so if you urgently need a personal loan to cover unexpected expenses or to pay for an emergency, you may not be able to do much to boost your score instantly.

    2. Check your credit report for mistakes.

    You can see each of your credit reports from Experian, Equifax and TransUnion at least once every 12 months for free. Look through the reports for accounts you don't recognize or misreported late payments. If you find mistakes, let the credit bureau know you'd like to dispute the information.

    It may take up to a month for the bureau to investigate and resolve your dispute. Credit repair companies can take care of this for you if you don’t have the time or energy to do it yourself.

    If your credit report includes past-due bills, work to get those resolved. You may be able to negotiate with the creditor to settle the debt so you pay less than the total amount due and get the remainder of the debt canceled. If you work out a deal like this, be sure to get it in writing before you send the payment. Also, never give a collection agency access to your bank account.

    3. Make your loan and credit card payments on time.

    Even one late payment can severely damage your credit score. If you have revolving credit accounts, pay down your balances. An ideal credit utilization rate (your total balances divided by the total amount of available credit across all your revolving accounts) is 30% or lower. Another way to improve your credit utilization ratio is to ask for a credit limit increase.

    4. Shop around for the best loan terms.

    With average to good credit, you can choose from a number of lenders. Don't take the first offer you receive, though — and check with your bank or credit union to find out if it offers the type of credit you need. Many smaller financial institutions have unadvertised low-interest loans or lines of credit reserved for their existing customers.

    5. Sign up for automatic payments.

    Your lender may provide an interest rate discount if you agree to automatic payments from your bank account. This also helps prevent you from damaging your credit score if you get busy and forget to make a payment.

    6. Choose a shorter loan term.

    A shorter loan term limits your lender's risk since you'll pay back the loan earlier. So, in general, a shorter term means lower interest rates. If you can afford larger monthly payments, choose a loan with a shorter repayment schedule to save money on interest.

    7. Improve your debt-to-income ratio.

    Your debt-to-income (DTI) ratio is your total monthly debt payments divided by your total gross monthly income. Lenders use this formula to determine whether you can easily make the monthly payments on your loan. Lenders like to see a DTI of 36% or less in general, although many will approve an applicant with a higher ratio.

    8. Consider adding a co-applicant with a higher credit score.

    If your credit score is too low to qualify for a loan with a low interest rate, adding a co-applicant with good credit could help you get a better one. Keep in mind that your co-applicant is just as responsible for the debt as you if they sign on, though, so be sure to make your payments to avoid them having to assume the debt for you.

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      Frequently asked questions about interest rates

      What are interest rates today?

      Interest rates vary over time depending on a number of factors, so it’s impossible to give an evergreen answer. The Federal Reserve sets the fed funds rate, which affects variable and short-term interest rates. Investor demand for U.S. Treasury notes and bonds has an effect on fixed and long-term interest rates. The banking industry also influences interest rates.

      Is it better to pay off interest or principal first?

      Ideally, you’d want to pay off your loan principal first. Once that’s paid off, you won’t have a debt to generate interest anymore.

      However, many loans are structured so that your early payments go mostly toward interest. Lenders want to receive the interest on the loan as soon as possible — that's how they make money. Unless there's a prepayment penalty attached to your loan, consider making extra payments toward the principal to decrease the total amount of interest you'll pay throughout the life of the loan.

      Your lender determines the ratios and totals of your monthly payments based on the amount you borrow, your interest rates and fees and your loan term. If you decide to make extra payments, let the lender know you'd like those to go toward paying down the principal. Otherwise, it may record your payments as early monthly payments, which won't save you money on interest.

      How do you calculate daily interest on a loan?

      Divide the annual interest rate by 365 to calculate the daily interest rate for your loan. For example, a loan with a 10% annual interest rate would have a daily interest rate of 0.0273%. Convert that rate to a decimal (0.0273 / 100 = 0.000273) and multiply it by your remaining principal to see how much interest is accruing each day. If you had $10,000 in principal left on our example loan, you’d be charged roughly $2.73 per day in interest.

      Bottom line

      When you borrow money, it's important to pay close attention to your interest rate and how your lender calculates your monthly payments. Before you accept the funds, use an online calculator to add up exactly how much interest you'll pay over the life of the loan. Consider reducing the term of the loan to see if you can afford a slightly larger monthly payment in exchange for paying less interest over time.

      Borrowing money costs money, so proceed with caution when you take out a loan. Paying off your balance faster could save you money if you’re not subject to prepayment penalties.

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