When taking out a loan, it's imperative that you consider the amount being borrowed as well as the interest you will end up paying throughout the life of the loan. Educating yourself about interest rates beforehand will equip you with the information you need to make informed decisions that fit you or your company's budget.
In this article, we'll define interest rates, explore the various factors that affect loan payments and provide the steps for calculating your monthly interest payment.
Related: 6 Essential Accounting Skills
What are interest rates?
There are many different types of loans, such as credit cards, home mortgages and car loans. When borrowing money from a lender, regardless of the type of loan, they typically ask for you to pay back the initial amount that you were lent along with a fee for borrowing the money. This fee is called interest. Interest rates are a percentage of the loan amount and are put in place so that lenders can make a profit from the loans that they issue.
Though there are many people and organizations that lend money while charging interest, it is most commonly used by banks. To encourage their patrons to make deposits, they pay them the interest on their account balances. Banks then use the funds in the checking and savings accounts to issue loans with interest rates. The interest for borrowers is usually higher than what is issued to depositors so that the bank can make a profit from the transaction.
For the most part, interest rates will vary depending on the loan amount, the term of the loan, the industry and the lender. Additionally, interest rates that are calculated monthly compound, meaning that the interest paid builds over time. An annual percentage rate, also known as an APR, is the rate charged each year over the course of the loan. APR incorporates additional fees that are charged in relation to the transaction without compounding the interest.
What affects how much a borrower pays?
Several variables determine the amount of money paid by the borrower to repay the loan, such as:
- Principal amount
- Loan term
- Repayment schedule
- Repayment amount
- Interest rate
The initial amount of money that you borrow is referred to as the principal. Interest rates are calculated by taking a percentage of the principal amount owed on the loan. Though knowing the amount of money you need is an important detail when borrowing from a lender, you should also consider the realistic amount of money that you can afford to pay back. To determine this number, think about your budget at various levels: weekly, monthly and yearly.
Additionally, you should spend some time to take into account any life changes that could affect your ability to pay for the loan. For example, are you planning to have kids? Are you considering going back to school? Is there a big move that you're preparing for?
The term of the loan determines how long you have to repay the money that you borrowed. When a loan term is shorter, it usually increases the principal amount owed for each monthly payment. However, it also results in less interest being paid over time. On the other hand, longer terms typically decrease the amount owed each month but result in more interest being paid throughout the life of the loan.
Let's look at a mortgage as an example:
You have taken out a mortgage for $150,000 with a 3.5% interest rate to buy a home.
If you decide to go with a standard 30-year loan, your monthly payment would be $674 with a total of $92,544 being paid in interest over the course of the loan.
If you choose a 15-year loan, you would owe $1,072 per month and $43,018 of interest throughout the life of the loan.
In other words, it is ultimately more cost-effective to choose a shorter loan term, but the monthly payments are substantially higher.
Most loans follow a monthly repayment plan. However, you can also choose to make your payments weekly or bi-weekly. Your personal budgeting style will determine the schedule that is best for you. As with a shorter loan term, frequent repayments result in less interest being paid over time.
When repaying a loan, the amount owed is typically comprised of two parts:
- The interest owed over the course of the loan
- The balance of your initial loan amount
Banks frequently use what is referred to as amortizing loans. These loans are calculated to provide a set monthly payment that encompasses both principal and interest. By the end of the loan term, both variables are repaid. Even with amortizing loans, your principal determines the amount of interest that you pay. If possible, you can make additional payments towards your principal each month to decrease both the term of the loan as well as the amount of interest that you will owe over time.
When determining the amount of interest for a loan, avoid using the comparison rate. Unlike the annual interest rate, a comparison rate includes the additional fees and charges associated with your loan, which would cause your calculated interest to be over-inflated and inaccurate.
Related: Ultimate Guide to Strategic Planning
How to calculate your monthly interest
When determining your monthly interest rate, you can either utilize a free, online interest calculator or do the math yourself. If you decide to complete the calculations by hand, here are the steps you should take:
- Determine your annual percentage rate.
- Figure out the number of pay periods.
- Convert the annual rate to a monthly rate.
- Calculate the monthly interest payment.
1. Determine your annual percentage rate
To figure out your interest rate per month, you will first need to know your annual percentage rate. This number can usually be located on your most recent statement or original loan agreement. The variable "i" is commonly used to refer to the interest rate in these calculations.
2. Figure out the number of pay periods
Though some formulas take into account the total number of pay periods for the life of the loan, many simply use a standard 12-period payment plan regardless of whether the loan term is longer or shorter. In these calculations, the number of pay periods is represented by the variable "n."
3. Convert the annual rate to a monthly rate
Before determining your monthly interest payment, you will need to convert the annual percentage rate into a monthly rate. To do this, you will need to divide the interest dividend by the number of payment periods. Here is the formula to guide your calculations:
monthly interest rate = i / n
monthly interest rate = annual percentage rate / payment periods
4. Calculate the monthly interest payment
After you have found the monthly interest rate, you can use that number to find the amount of interest owed each month. This is accomplished by multiplying the monthly rate by the balance of the loan. You can use this formula:
monthly interest payment = monthly rate * principal balance