How to Calculate Interest on a Loan: Formulas and Examples

Interest is the cost you pay to borrow money from a lender. This fee is usually expressed as a percentage of the loan amount and is paid over time along with the principal.

Each loan payment you make typically covers both:

A portion of the principal (the amount you originally borrowed)
A portion of the interest (the lender’s fee)

Lenders may calculate interest using different methods, including simple, compound, or amortized interest.

Understanding which one applies to your loan helps you figure out how much you’ll have to pay over time.

Lenders might charge simple interest on personal loans, auto loans, and home loans. Simple interest is calculated only on the original loan amount (the principal).¹

Simple interest formula

You can use this formula to crunch the numbers:

Total interest = Principal x Interest rate x Time

• Principal = loan amount
• Interest rate = Annual interest rate (as a decimal)
• Time = Loan term in years

Simple interest example

Let’s say you take out a $5,000 personal loan with a 3-year term and an 8% interest rate.

The calculation would be: 

$5,000 x 0.08 x 3 = $1,200 total interest

In this case, you’d pay $1,200 in interest over the lifetime of the loan, plus the $5,000 principal.

Compound interest isn’t as common for installment loans, but it’s worth understanding, especially if you’re using a credit card or revolving credit.

Compound interest formula

Here’s a formula you can use for compound interest:
Compound interest = Principal × (1 + Rate / Number)^{(Number × Time)}– Principal

• Principal = Original loan amount
• Rate = Annual interest rate (as a decimal)
• Number = Number of compounding periods per year
• Time = Loan term in years

This formula is a bit more complex, which is why many people use a loan payoff calculator to estimate compound interest and total costs.

Compound interest example

Let’s say you borrow $5,000 with a 6% annual interest rate, compounded monthly, for 3 years.

• Principal (P) = $5,000
• Rate (r) = 0.06
• Number of compounding periods (n) = 12
• Time (t) = 3

Using the formula:

Compound interest = P × (1 + r / n)n × t – P

Compound interest = 5,000 × (1 + 0.06 / 12)12 × 3 – 5,000

Compound interest = 5,000 × (1.005)36 – 5,000

Compound interest ≈ 5,000 × 1.1967 – 5,000

Compound interest ≈ 5,983.50 – 5,000 = $983.50

So after 3 years, you’d pay about $983.50 in interest, with a total repayment of around $5,983.50.

Many loans – like student loans and mortgages – use amortized interest, where payments are split between interest and principal over time.

Early in your loan term, more of your monthly payments go toward interest. Over time, a larger portion goes toward the principal balance.

Amortizing interest formula

Although exact calculations can be complex, here’s one method for estimating monthly loan payments on an amortized loan.

Compound Interest = Principal × (1 + Rate ÷ Number of compounding periods)^{(Number of compounding periods × Time) – Principal}

• M = monthly payment
• P = Loan amount (principal)
• R = Monthly interest rate (annual rate ÷ 12)
• N = Total number of payments (months)

If this formula is freaking you out, don’t worry. Most people use an online loan calculator or amortization schedule to estimate costs.

Amortizing interest example

Below is the first-year amortization schedule for an $8,000, 3-year personal loan at 8% that starts payments in March 2025.⁴

• Annual interest rate = 8% → Monthly rate = 0.08 ÷ 12 = 0.00667
• Loan term = 36 months
• Monthly payment = roughly $250.69

Here’s what 6 months of the amortization schedule would look like:

Lenders consider several factors when you apply for a loan, like your income and monthly debt. These factors help determine your interest rate, which affects your total cost of borrowing.

Key factors include:

• Credit score: Generally speaking, the higher your credit score, the better your chances of getting a better interest rate.
• Lending institution: Rates vary depending on the lender you apply with.
• Market conditions: Interest rates rise and fall based on economic trends and decisions made by the Federal Reserve.⁵
• Loan type: Average rates vary depending on the type of debt. For example, based on the requirements of a personal loan, these loan types often have lower average rates than credit cards.
• Loan terms: Longer repayment terms may come with higher interest rates.⁶
• Income and debt-to-income ratio: Lenders assess your ability to repay debts.

Yes – making extra payments or paying off your loan early can reduce the total interest you owe. This works especially well for simple interest loans and early in amortized loan terms.

However, before you pay off your loan early, ask your lender if they charge a pre-payment penalty fee.

A lower loan interest rate can save you hundreds – or even thousands – over time. Use these tips to improve your chances of securing the best rate available:

1. Compare offers from multiple lenders

Don’t accept the first offer you receive. Prequalify with at least 3-5 lenders to compare interest rates, loan terms, and fees. Many lenders let you prequalify with a soft credit check.

2. Improve your credit score

If you have time before applying, work on boosting your credit score:

• Pay down outstanding debts
• Make on-time payments
• Fix any errors on your credit report

Better credit generally leads to better rates.

Lower your debt-to-income ratio (DTI)

Lenders use your debt-to-income ratio to evaluate how much existing debt you have. Reducing your debt — or increasing your income — can help you qualify for lower interest rates.

Apply with a co-signer

Adding a co-signer who has strong credit and a stable income can improve your loan terms. Just be sure they are financially responsible.

To figure out how much you can borrow, first create a monthly budget that includes:

• Take-home pay
• Fixed expenses (rent, utilities, subscriptions)
• Variable expenses (groceries, entertainment)

If your current budget is tight, consider cutting back discretionary spending or increasing income before taking on new debt. Also, factor in emergency savings for unexpected costs.

If you’re looking to build good credit for better loan terms in the future, check out how to improve your credit score.