When you pay interest, you pay a fee for using somebody else’s money. In addition to returning their money, you pay a little extra. Knowing how to calculate interest helps you understand what it costs to borrow and it makes it easier to choose the best loan.
With most loans, you repay with regular (typically monthly) payments. Each payment is broken into two parts:
- A portion of the payment repays your loan and reduces your loan balance
- A portion of the payment is your interest cost and is income for your lender
Other loans are different and you’ll calculate interest costs with other methods. For example, interest only loans and credit cards do not work like traditional home loans.
How to Calculate Interest You Pay
When loans are paid off over time with regular and level payments, they’re called amortizing loans. Lenders figure out what your monthly payment will be based on the specifics of your loan. When doing these calculations, they can create an amortization schedule or table showing interest costs, loan balances, and more.
- How much you’ll borrow
- How long you have to repay the loan (and how often you pay)
- Your interest rate
Calculating Interest and APR
It’s important to use the correct rate when you calculate interest costs, but rates can be confusing. Loans may be quoted in terms of annual percentage rate (APR). APR is important, but it may include more than just your interest cost. To accurately calculate interest costs, use the interest rate (or nominal interest rate) -- not APR.