Lenders typically charge interest when you take out a loan. As you make payments, you pay this fee and your outstanding balance.
How a lender calculates interest depends on whether it uses a simple or amortized interest method. The interest rate charged will depend on factors like your credit score and income.
Want to know how much you could get charged in interest when you take out a loan? We’ll teach you how to calculate interest on a loan to help you assess how much you can afford to borrow. Plus, we’ll share some tips for securing a better rate.
What is interest on a loan, and how does it work?
Interest is what a lender charges you for borrowing money. This fee is a percentage of your loan amount.
When you repay your loan, a portion covers the principal or original balance, and the rest covers interest charges.
The exact formula a lender uses to calculate interest varies, but two popular methods are simple interest and amortizing interest.
Calculating simple interest on a loan
Lenders might charge simple interest on various financial products, including personal loans, auto loans, and home loans. Simple interest is calculated based on the amount you borrowed.¹
If a lender charges simple interest, you can calculate the total interest if you have this information:
- Principal or loan amount
- Interest rate
- Repayment term or time
You can use this formula to crunch the numbers: Principal x interest rate x time = total interest.
For example, if you took out a $5,000 simple-interest personal loan with a 3-year term at 8%, you’d multiply $$5,000 x .08 x 3 to get $1,200 in total interest.
Calculating amortizing interest on a loan
Some lenders charge amortizing interest. These loans have fixed payments like simple interest loans. However, the difference is that most of the initial payments at the start of the repayment period go toward interest.
Over time, the interest you pay each month decreases. As a result, more of your payment goes toward paying down your original balance.
It’s common for lenders to charge interest on personal loans, student loans, and mortgages according to an amortization schedule.²
You could use an online calculator to help you. That said, here are the steps you can take if you want to learn how to create an amortization schedule from scratch:
- Calculate your monthly interest rate: Divide your interest rate by the number of payments you’ll make during the year. For example, if your rate is 9% and you make 12 payments each year, divide 9% by 12 to get .0075.
- Calculate your first interest payment. Next, calculate your monthly payment by multiplying your loan amount by .0075. If your outstanding balance is $8,000, $60 of your first payment would cover interest.
- Calculate your first principal payment. Subtract the interest charge from your monthly payment to see how much of your first payment goes toward the principal. If your monthly payment is $300, $240 would go toward the $8,000 principal balance. Your new outstanding balance would be $7,760.
- Repeat the steps. Repeat the second and third steps to see how much of your monthly payment will go toward interest and principal in future months.³
Below is the first-year amortization schedule for an $8,000, 3-year personal loan at 8% that starts payments in March 2024.⁴
Due date | Monthly payment | Interest | Principal | Ending balance |
---|---|---|---|---|
3/2024 | $250.69 | $53.33 | $179.36 | $7,802.64 |
4/2024 | $250.69 | $52.02 | $198.67 | $7603.97 |
5/2024 | $250.69 | $50.69 | $200 | $7,403.97 |
6/2024 | $250.69 | $49.36 | $201.33 | $7,202.64 |
7/2024 | $250.69 | $48.02 | $202.67 | $6,999.97 |
8/2024 | $250.69 | $48.67 | $204.02 | $6,759.94 |
9/2024 | $250.69 | $45.31 | $205.38 | $6,590.56 |
10/2024 | $250.69 | $43.94 | $206.75 | $6383.80 |
11/2024 | $250.69 | $42.56 | $208.13 | $6,175.76 |
12/2024 | $250.69 | $41.17 | $209.52 | $5,966.15 |
1/2025 | $250.69 | $39.77 | $210.92 | $5,755.24 |
2/2025 | $250.69 | $38.37 | $212.32 | $5,542.91 |
Factors affecting loan interest rates
Lenders consider multiple details when you apply for a loan, like your income and monthly debt load.
What interest rate you receive also depends on other factors, such as:
- Your credit score: Generally speaking, the higher your credit score, the better your chances of securing a more favorable interest rate.
- Lending institution: Rates vary depending on the lender you apply with.
- Market environment: When the Federal Reserve thinks the prices of goods and services have gone up too much, it often raises interest rates. As a result, lenders might charge consumers more to borrow money. On the other hand, the Fed might lower rates if it thinks prices have fallen too much.⁵
- Type of loan: Average rates vary depending on the type of debt. For example, based on the requirements of a personal loan, they often have lower average rates than credit cards.
- Repayment terms: Lenders may charge a higher interest rate depending on the repayment term you choose. For example, mortgage lenders often charge higher rates for longer-term mortgages than shorter-term mortgages.⁶
Can I pay off my loan early to save on interest?
Making extra payments on your loan can reduce the total interest paid over the life of the loan. Before you pay off your loan early, ask your lender if it charges a pre-payment fee.
Check out our loan payoff calculator to see how extra payments can affect how fast you pay off your loan.
Strategies for getting the lowest loan interest rates
Some steps you could take to increase your chances of getting the best rate for your financial situation include:
- Shop around: To find the best deal for your financial circumstances, compare loan offers from at least three to five lenders. Some lenders allow you to prequalify online to preview rates and terms you might receive after submitting a complete application. Keep in mind that prequalifying doesn’t mean guaranteed approval.
- Improve your credit score. If you don’t need to borrow money immediately, consider taking steps to boost your credit score before applying for a loan. For example, you could review your credit report for errors or pay down debt.
- Pay down debt: When you apply for a loan, lenders generally consider your debt-to-income ratio (DTI) to assess whether you can handle additional debt payments. Paying down debt lowers your DTI. As a result, lenders might offer you a better rate.
- Apply with a co-signer: Adding a co-signer with good credit and a decent income to your loan application could improve your chances of securing a lower rate. Before you get someone to cosign, make sure they’re aware of the risks. For example, if you default on the loan, it could harm your credit and theirs.
- Consider a secured loan: Lenders often offer lower rates on secured loans because you have to pledge an asset – like a bank account or car title – to qualify. If you default on the loan, the lender can seize the asset to satisfy the debt.
Figuring out how much of a loan you can afford
The loan amount you qualify for, if a lender approves you, will depend on:
- Your income
- Current debt
- Credit score
Before you take out a loan, review your expenses and income to decide whether you can comfortably repay it.
- Create a budget: Make a budget if you don’t already have one. You can do this by writing down your income and expenses, like your phone bill and monthly entertainment expenses, on a piece of paper or using a budgeting app.
- Adjust expenses. Review your budget to identify expenses you could trim if you want to take on a larger loan than your current budget allows. Also, consider emergencies like unexpected car repairs or medical expenses.
Know your total borrowing costs before taking out a loan
Before borrowing money, understand the total interest you’ll pay over the life of a loan. To ensure you use the correct formula to calculate the costs, ask the lender whether it charges simple interest or the loan has an amortization schedule.
Having good credit could help increase your chances of qualifying for a loan with a lower rate. If you’d like to learn how to build credit, read our tips for improving your credit score.