How personal loan interest is calculated

When it’s time to evaluate your financial options, getting clarity about what you’re looking at is half the battle. Understanding how interest works is like unlocking a secret door that leads to well-informed financial decisions that you can feel good about.

If you're thinking, No thanks, I don't do math, here’s a spoiler: You don’t need to. We’ll break down the basics so that you can use online calculators and tools with confidence, knowing exactly what you’re looking at when the results appear on the screen. 

Interest on a loan is a fee that the lender charges to the borrower. When you get a loan, the lender sets an interest rate, which is the percentage you pay per year on the amount you borrowed. Most lenders charge interest on a monthly basis, although this can vary depending on the lender.

The basics: what lenders use to calculate interest

Lenders calculate interest on personal loans and other types of loans using three factors:

• Principal: The amount you borrow

• Annual percentage rate (APR): The annual cost of your loan

• Loan term: The length of your loan

The principal and loan term are largely up to you. When you apply, you decide how much you want to borrow and for how long. The lender determines your loan’s APR, which is primarily based on your credit score and overall credit profile. If you have good or excellent credit, you could qualify for a lower rate.

Those are the three basic factors that lenders use in interest calculations. However, the interest formula also plays a key role in how much interest you pay.

How is interest on a personal loan calculated? Personal loan interest is calculated using your loan amount, APR, and term. Lenders use amortization, which divides each monthly payment into interest and principal. Early payments include more interest, and later payments reduce your principal balance faster.

Simple interest formula (easy estimate)

Simple interest refers to interest based only on the principal of the loan. If a loan has simple interest, you can figure out how much interest you’re going to pay fairly quickly. The simple interest formula is the loan principal multiplied by the interest rate and the term, or:

• Simple interest = (Principal x interest rate x term)

It’s easy to explain with an example. Imagine you get a $10,000 personal loan that charges simple interest. It has a 16% interest rate and a three-year term. Multiply $10,000 by the 16% interest rate to get $160. Then, multiply $160 by 3 (the length of the loan in years). The result, $480, is the total amount of interest you’d pay.

Most personal loans use amortized interest. The key difference is that amortized interest is based on your loan’s remaining balance, not the original amount you borrowed. This means it’s possible to pay less interest if you pay down the balance ahead of schedule.

What is 5% interest on $5,000? 5% interest on $5,000 is $250. In this interest example, you’d pay that much interest each year that you had the loan.

How amortized interest works (real loan method)

Amortized loans have fixed monthly payments. The amount you need to pay each month remains the same for the life of the loan. What changes is the portion of the payment that goes to the loan principal and to interest charges. Early payments include more interest charges, and later payments pay more of the loan principal.

For example, you get a two-year amortized loan for $5,000. It has a 16% interest rate and fixed monthly payments of $244.82. The table below shows the amount of principal and interest paid by your first and last monthly payments.

How do banks calculate interest on a loan? Bank interest calculations can vary depending on the bank, but they typically multiply the APR by the remaining loan balance.

Why early payments include more interest

Lenders calculate amortized interest using your loan’s remaining balance. The remaining balance is highest when you first get the loan, and then decreases over time.

A larger balance means the lender charges you more interest. As the balance decreases, so do the interest charges, and more of your monthly payments go toward the principal.

The chart below uses the example from earlier of a two-year amortized loan for $5,000. The amount of interest per payment shrinks over time. At the beginning, over a quarter of your monthly payment goes toward interest. By the end, you’re only paying a few dollars in interest.

What affects total interest paid?

The amount borrowed, loan term, and APR all affect the total interest paid for a loan. An increase in any of these factors could increase the amount of interest you pay.

For example, you want to borrow $10,000, and you qualify for a 14% APR. You’re deciding between a three-year loan or a five-year loan. Here’s how much the term would change the total interest paid:

• Three-year loan: $2,303.95 in total interest

• Five-year loan: $3,960.95 in total interest

You save $1,657 if you go with the shorter loan. But you’ll have a higher monthly payment—$341.78 with a three-year loan compared to $232.68 with a five-year loan. If you can manage that higher monthly payment, you could get out of debt sooner and at a much lower cost by choosing the shorter loan term.

How to reduce the interest you pay

If you currently have a loan, here are a few ways to reduce the interest you pay on it:

• Refinance your loan to get a lower APR. When you refinance a loan, you replace your original loan with a new one. If your credit has improved since you got the loan, you could qualify for a better rate.

• Make extra payments. Extra loan payments can go directly toward the loan principal, potentially resulting in lower interest charges overall. It’s important to tell your lender that you want your extra payments to go toward the principal, as not all lenders do this automatically.

• Avoid late fees and penalty APRs. Lenders typically charge late fees if you don’t pay on time. If your payment gets too far past due, the lender could also start charging you a penalty APR that’s higher than your loan’s normal rate.

Going forward, focus on improving your credit by paying down debt and always paying bills on time. You can also use free credit score tools online to monitor your credit and find out how to improve it. A higher credit score could help you qualify for lower rates in the future.

If you’re looking for a loan, personalized advice could help you find one that fits your needs. Talk to a loan consultant today for assistance in getting a low-interest, fixed-rate loan with a fast application process.