How is interest calculated on a loan
How is the Interest on a Loan calculated?
Every loan is associated with different costs, but the most important part of the cost of credit is the interest. The amount of interest you pay to the bank throughout the life of the loan is proportional to the level of interest rate and length of the repayment period. In this article we briefly present the general principles of calculation of interest.
Above all, you should remember that the interest rate of the loan is always given on an annual basis (this is a generally accepted method not only for loans, but also for deposits, payments, etc.). Installment is paid on a monthly basis, which means that for each month the bank calculates interest from the amount of capital remaining to be paid, with the annual interest rate in proportion to the number of days in that month (that's why 31-day month interest will be higher than the amount of interest for a month having 28 or 30 days). In the calculation it is usually assumed that a year has 365 days.
You can repay a loan in equal or decreasing installments. Every installment contains repayment of capital and the amount of interest.
The difference between these two systems of repayment is simple:
- in equal installments schedule - the amount of the installment is constant, amounts of capital and interest change every month;
- in decreasing installments schedule - the amount of capital is constant in every month, and amounts of installment and the interest change every month.
In case of equal installments, the amount of installment includes the amount of
interest calculated for the month in question, and the remainder is the repayment of capital. In short months (for example February or the 30-day months) the share of capital in the installment is slightly higher than in the long months (31-day months) because the calculated interest amount is lower and there is more "space" left for the repayment of principal.
In the decreasing installments schedule, the amount of interest is added to a fixed amount of capital, repayable on a monthly basis. The entire amount of capital to be paid off decreases every month, so in every following month the amount of interest is lower. That's why, the installment is decreasing.
Below we present an example of calculation of interest on the loan, in which the remaining capital to be paid off is $200,000. The interest rate on the loan is 4%, and accrued interest shall be for 30-day period.
Interest = $200.000 * 0.04 * 30 * / 365 = $657.53.
In the above case, when repaying the loan in equal installments in a period of 30 years, the monthly installment will amount to $954.83 (You can calculate the installment in our loan calculator ).
Thus, the capital of the installment for the month is:
$954.83 - $657.53 = $297.30.
In this way, in every month you can calculate the share of capital and interest in equal installment (these proportions will change for each month - they will vary depending on the outstanding amount of principle and the length of the month).
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