A borrower’s guide to interest calculations on loans

Key takeaways:

• Loans typically use either simple interest – with consistent interest payments – or amortizing interest, where interest payments decrease as the loan balance is paid down.
• Simple interest is straightforward to calculate using the formula principal × interest rate × term, while amortizing interest requires ongoing calculations or an amortization schedule.
• You can secure better interest rates by improving your credit score, lowering your debt-to-income ratio, making larger down payments, comparing lenders, and considering shorter loan terms.

Ever wonder why banks and lenders charge interest and how they determine interest calculations on loans? Charging interest is one of the primary ways lenders make money. If you plan to pursue a personal loan, calculating how much you’ll pay in interest can help you choose a lender, decide your preferred loan terms, and budget appropriately. That’s why it’s important to understand your interest rate and the type of interest charged for each loan you may be considering – well before signing on the dotted line.

It’s natural to wonder how to calculate and charge interest on a personal loan. There are two ways: simple interest and interest amortization. This guide will define both types, explain how interest is calculated on your loan, and provide tips for getting the best possible interest rate.

What type of interest does your loan have?

Lenders typically charge interest in one of two ways: simple interest or amortizing interest. The loan type usually dictates which type of interest you’ll be charged, although some loans can charge either type. More on these next.

This article will focus on personal loans with fixed interest. Be aware that interest calculations are more complicated when it comes to variable interest rate loans. That’s because variable rates change, per the loan agreement and market fluctuations.

Simple interest

Simple interest is the easiest type to calculate. You’re more likely to encounter simple interest with a short-term loan like a personal loan. The amount of interest you’ll pay is calculated based on your original loan balance, your interest rate, and the length of your repayment period. A fixed portion of each payment you make goes toward the principal loan amount borrowed and also toward the interest you owe. Those amounts don’t change as you make payments.

For example, if $20 on your first payment goes to interest, $20 of your last payment would also go toward interest.

“Your daily interest is based on what you still owe, and the faster you pay it down, the less interest you’ll pay over time,” says Ryan Zomorodi, COO and co-founder of Real Estate Skills. “Simple interest loans are more straightforward and benefit borrowers who make consistent or early payments.”

Some lenders use the term “simple interest” solely to differentiate it from compound interest, which we’ll talk about later. Here, we’re using it to describe both how the interest is calculated and how simple interest loans are repaid. Simple interest does not compound, and the interest portion of your payment is consistent as you repay the loan.

Amortizing interest

With amortizing interest, the amount of your payment that goes toward interest will change from month to month. To be clear, this happens even with a fixed interest rate. Your interest rate itself doesn’t change, but the amount of each payment that goes toward your interest does.

Amortizing interest is front-loaded: That means it’s always structured so that you pay more in interest early in the loan repayment process, when your balance is the highest. As the balance decreases, more and more of your payment goes to the principal balance and less goes to interest because you’re paying interest on a smaller remaining principal amount. (We’ll demonstrate this with an amortization schedule later.)

“This establishes a steady, gradual path to complete repayment and is typical for mortgages, student loans, and many business loans,” says Dennis Shirshikov, a professor of economics and finance at City University of New York/Queens College.

Some amortizing loans use compound interest. This means that interest is calculated on the principal loan amount and on your accumulated interest. Interest will accrue on your balance based on the compounding schedule. This can be daily, weekly, monthly, semiannually, or annually.

Lenders are much more likely to use amortizing interest than simple interest, but it’s always worth confirming which is going to be in effect – especially with a short-term loan.

Common loans and their typical interest types

To give you an idea of which loans typically use which type of interest, here’s a table that breaks it all down:

As you can see, some loans use simple interest, others use amortized interest, and some use both. For example, all federal student loans use simple interest, but that’s not always the case with private student loans. And mortgages almost always use amortizing interest, but simple-interest mortgages do exist.

“Shorter-term agreements like auto loans, some personal loans, and some business loans frequently have simple interest rates,” Shirshikov says. “Generally speaking, longer-term asset-backed loans have amortized interest”

Although most lenders use amortizing interest, you should never just assume this to be so in your situation. Instead, check with your lender to verify which type of interest they use. Loan products offered by Rocket Loans^SM use amortizing interest.

How to calculate simple interest on a loan

Understanding how simple interest is calculated requires following an easy formula: Loan amount multiplied by interest rate multiplied by years of loan term equals total interest over the life of the loan. (Since the interest rate is a percentage, that variable will be a decimal.)

Put another way, the calculation for simple interest is:

(p x i)t

Here, p means principal, i means interest rate, and t means term.

Suppose you want to take out a $10,000 personal loan at a 5% simple interest rate with a 3-year repayment term. If so, your calculation would look like this:

$10,000 x 0.05 x 3 = $1,500.

To estimate the monthly cost under simple interest, divide your total interest by the months in the repayment term.

In this example, that would be $1,500 / 36 = $41.67.

You would pay approximately $41.67 in simple interest every month, from the first payment to the last.

How to calculate amortizing interest on a loan

Calculating amortizing interest is more complicated than calculating simple interest. That’s because your fixed payment is allocated differently over time. The easiest way to calculate amortizing interest is to use our loan calculator, which will show the complete amortization schedule.

If you prefer to do it yourself, here are the steps:

• Interest rate / number of payments you’ll make in a year = Y (The value will always be a small decimal)
• Y x remaining loan balance = X (How much you’ll pay in interest that month)
• Monthly payment minus X = How much of that payment will go to the principal

Let’s go through the steps again, this time with numbers. In this instance, let’s say you owe $7,000 on your personal loan with an 8% fixed interest rate. Your monthly payment is $417.50.

• .08 / 12 = 0.00667
• .00667 x $7,000 = $46.69
• $417.50 - $46.69 = $370.81

These calculations reveal that, out of your $417.50 monthly payment, $370.81 will go toward the principal and $46.69 will go to interest.

One downside to calculating amortizing interest by hand is that you’ll need to redo the calculation each month as the remaining loan balance decreases.

Remember, interest is just one piece of your monthly payment on a loan. Make sure you understand how all the pieces fit together.

Amortization schedule

Your lender should provide you with an amortization schedule. This table shows exactly how your payments will be distributed each month over the life of your loan.

Below is an example. This is for a $10,000 personal loan that has a 15% interest rate and a 2-year repayment term.

Tips for getting the best possible interest rate

Knowing how to calculate your interest helps you better understand the impact of interest on each of your monthly loan payments. Remember: The lower your interest rate is to begin with, the less interest you’ll pay over the life of the loan – regardless of how it’s calculated. Here are some tips to help you find the best possible rate:

• Improve creditworthiness. The higher your credit score, the better the loan terms a lender can offer you. “I recommend maintaining a credit score above 740. I’ve seen this strategy drop interest rates by up to 1 percentage point,” says personal finance expert Andrew Lokenauth. One of the easiest ways to boost your credit score is to pay your bills and debts on time. This demonstrates that you can be trusted with credit and can handle your finances responsibly. Keep in mind that your payment history holds the most weight in credit score calculations – accounting for 35% of your credit score.
• Decrease your debt-to-income ratio (DTI): Your DTI is another critical factor that lenders consider. If you take the time to lower your DTI and improve your credit before shopping around, you might be shocked by how much you can save in interest, especially over the entire loan term. You can decrease DTI by paying down your debts and paying them off quickly. “Try to keep your DTI ratio under 36%. One of my clients recently lowered their rate by 0.5 percentage points just by paying off a small credit card balance, which lowered their DTI,” Lokenauth says.
• Allocate a bigger down payment: A down payment isn’t required for all loan types, but you’re always better off in the long run if you can put down more money – or at least some money – up front. First, you’ll be borrowing less money overall. Second, lenders can adjust your interest rate based on how much you put down, and they might give you a better deal. A larger down payment shows your lender that you have the financial resources to ensure a lower loan-to-value ratio.
• Get prequalified with different lenders: The good news is that prequalification doesn’t impact your credit score, and it’s one of the most important steps when considering any type of loan. Getting prequalified will allow you to view an estimate on how much you could borrow, as well as the interest rates and terms you could receive from the lender. Prequalification also enables you to compare the best rates to find the most affordable loan products. Not all lenders price their loans the same, so it’s worth taking the time to talk with more than one lender. “Don’t be afraid to negotiate – some lenders will match or beat competitor rates if you ask,” Zomorodi says. Be sure to look closely at the annual percentage rate (APR) in addition to just the interest rates you see.
• Opt for a shorter repayment term: Shorter repayment terms often result in lower interest rates. Your monthly payment will be more, but you’ll pay less in interest. This will save you money over the life of the loan.

FAQ: Calculating interest on a loan

There are many nuances to consider when discussing interest on loans. So we’ve put together a helpful FAQ section to further guide you.

Is the method for calculating interest different for each type of loan?

No, it isn’t. For example, an amortization schedule for a car loan with compounding interest would work the same way as an amortization schedule for a mortgage. The number values would obviously differ, but the formulas are the same.

However, if you change the interest type, it will be calculated differently – even for the same loan type. Case in point: A personal loan that uses simple interest will be calculated differently from a personal loan with amortizing interest.

How do I calculate interest on a loan with a variable interest rate?

Truth is, you can’t forecast how rates will change over time. So it’s impossible to accurately calculate interest on a loan with a variable interest rate. You can make predictions by inputting different interest rate values for different time periods, but you’re using ballpark estimates versus hard data points.

Predictability is one of the biggest advantages of fixed-rate loans over variable interest rate loans.

Can I deduct loan interest from my taxes?

It depends on the type of loan, but it’s possible. Interest paid on student loans and mortgages is frequently tax-deductible. Unfortunately, the interest on personal loans is generally not tax-deductible.

The bottom line: Interest rate calculations impact borrowing costs

It’s a good idea to know how interest is calculated when researching loan options, including personal loans. After all, simple interest in amortized interest calculations results in very different borrowing costs. But while calculating the interest you’ll pay is important, that's not all that goes into getting a loan. Be sure to shop around before committing to a lender, and even once you’ve been approved, take the time to ask your lender any questions you have before signing the paperwork. Once the funds are disbursed, you’re on the hook to repay them.

Ready to take out a personal loan? Get prequalified with Rocket Loans. This way, you can estimate your monthly payment as well as how much you’ll pay in interest each month and over the full repayment term.