Interest Rates: What They Are and How To Calculate Them
Updated October 5, 2021
Published February 25, 2020
Gillian Davenport is a business writer with professional experience in finance and accounting. She is passionate about making complex financial concepts clear and accessible for clients and readers alike.
Individuals and organizations may pay interest when borrowing money as a loan or credit card transaction. Interest rates can vary depending on a person's credit score, financial history and the amount of money they owe. Understanding how they work can help professionals with their financial planning or allow a business to complete an annual budget. In this article, we define what an interest rate is, discuss important information for calculating one and review steps that describe how to calculate monthly interest rates and rates for loans and credit cards.
What is an interest rate?
An interest rate is a portion of a loan that's expressed as an annual or monthly percentage of the outstanding loan amount. Individuals and organizations pay this fee regularly at a predetermined rate along with portions of the loan until they pay the borrowed amount back in full. This means that interest rates are charges in addition to loan payments, so the lower the interest rate an organization has, the less money they pay.
The percentage of the interest rate varies depending on the amount of risk and collateral associated with the loan, among other factors. For example, credit cards typically have higher interest rates because they lack the security of collateral. Alternatively, mortgages and car loans typically have lower interest rates because they can offer valuable collateral to secure the loan.
Important information for calculating an interest rate
There are several factors that may influence your calculations when determining an interest rate. Calculating an interest rate requires several pieces of information, such as:
Length of the loan term
The loan's term dictates how long the borrower has to repay the money that was lent to them. Shorter loan terms typically mean higher monthly payments toward the principal amount that's owed, but with less overall interest paid throughout the life of the loan. Alternatively, longer loan terms mean a decrease in the monthly payment but cause more interest to be paid for the duration of the loan payments.
Principal amount borrowed
The principal is the total amount of money lent to a borrower before they've made any payments to repay the lender. The lender calculates an interest rate by taking a portion of the principal amount that the lender owes on the loan. In addition to paying an interest rate with every payment, lenders also contribute to paying back the principal amount.
Annual interest rate
Identifying the annual interest rate suggested by the lender allows you to calculate the dollar amount to pay monthly, quarterly or biannually. It's important that you use the annual interest rate over a comparison rate to ensure your calculations are as accurate as possible. Comparison rates include various charges and fees that are associated with your loan, so only use your annual rate when evaluating interest.
Schedule for repaying the loan
Repayment schedules typically vary depending on the type of loan, although many loans and mortgages use a monthly plan of repayment. You may be able to choose to make payments following a schedule that works best for you and your budgeting style. Consider that the more frequently you make payments, the less interest you pay throughout the duration of the loan. This means you may save money by making more payments within a shorter amount of time.
Remaining balance of the loan
The amount owed on a loan typically includes the remaining balance of the principal and the interest that the lender owes throughout the duration of the loan. Lenders and banks typically provide a set monthly payment that includes both the interest and principal. They may use amortizing loans, which allow both variables to be repaid by the end of the loan's term. You have the option to make additional payments toward your principal with an amortizing loan, allowing you to decrease the amount of interest owed throughout the duration of the loan while reducing the length of the loan's term.
What do lenders consider when calculating an interest rate?
Lenders may consider a variety of factors when calculating an interest rate for an individual or a business. The United States Federal Reserve sets a general interest rate, and from that number, banks can decide on the annual percentage rate (APR) range they may offer. When evaluating the prospective interest rate for a person, lenders may consider their credit score, and consumers with higher credit scores may receive lower interest rates. Credit card companies can also review your payment history, because it may indicate the likelihood that you plan to regularly make credit card payments.
Please note that none of the companies mentioned in this article are affiliated with Indeed.
How to calculate a monthly interest rate
You may use a free online interest rate calculator to determine your monthly interest rate. If you prefer to calculate the rate by hand, consider following these steps:
1. Identify your annual percentage rate
Determining your monthly interest rate requires understanding the APR for your loan. You can usually find this number on your original loan agreement or on your most recent loan statement. In these calculations, professionals often use the variable 'i' to represent interest rates.
2. Determine the number of total pay periods for the loan
There are a few formulas that account for the total amount of pay periods throughout the length of the loan term, but most use the relatively standard 12-period payment period regardless of the actual life of the loan. When completing these calculations, lenders typically use the variable 'n' to represent the number of pay periods.
3. Convert your annual rate into a monthly rate
Convert your APR into a monthly rate before calculating your payment towards interest each month. To convert an annual rate into a monthly rate, divide the interest dividend by the number of payment periods, which is typically 12. Here's an example of the formula you can use for these calculations:
Monthly interest rate = annual percentage rate / the number of payment periods
4. Calculate your monthly payment toward interest
Now that you've found your monthly interest rate, you can then use that number to calculate the amount of interest to pay each month. You can do this by multiplying the balance of the principal for your loan by the monthly rate that you previously calculated. You can use this formula:
Monthly interest payment = monthly interest rate x balance of principal
Read more: How To Calculate Monthly Interest Rates
How to calculate an interest rate for a loan
Typically, lenders consider amortized loans to be personal, car and home loans. These loans have monthly payments that include both a portion of the total amount of principal and the interest that you owe for the entire loan term. Because you can make additional payments toward the loan's principal throughout the life of the loan, the amount of interest you owe may fluctuate. Here are some steps that you can take to calculate your remaining interest after making payments:
1. Determine the amount you paid on the loan
To understand how much you still owe on a loan, review the amount you've already paid toward the principal. You can usually find this information on your latest loan statement. When evaluating the finances you've already paid, remember to account for the portion of your payments that are interest, rather than a portion of the principle.
2. Identify the new balance
Once you understand the amount you've paid toward your principal, you can use that number to calculate how much you still owe. This can help you evaluate how many payments you have remaining until you pay off the loan entirely, allowing you to budget your finances accordingly. Follow this formula:
New balance = principal - (amount repaid - monthly interest payment)
3. Calculate your monthly interest payment
Finally, you can put your remaining balance back in to find your new monthly interest payment. This can demonstrate how interest rates can change depending on the amount of principal you owe to a lender. Here's the formula you can use to calculate your monthly interest payment:
Monthly interest payment = monthly interest rate x balance of principal
How to calculate an interest rate for a credit card
Although lenders rarely consider credit cards to be traditional loans, you may benefit from understanding them this way. Because you're paying the credit card company to use their money, you can consider it to be similar to a traditional loan. Before beginning your calculations, identify your annual percentage rate, the average balance for each day and the number of days that are in your billing cycle. Here are steps you can use to find the interest you're paying every month:
1. Determine the daily interest rate
When calculating an interest rate for a credit card, first identify the daily interest rate. Divide your annual percentage rate by the number of days in the year. You can use this formula:
Daily interest rate = APR / 365
2. Find the daily interest payment
Next, you can multiply your average daily balance by the daily interest rate. Your average daily balance is the average amount of money you owe to a credit card company per day. To find your daily interest payment, follow this formula:
Daily interest payment = average daily balance x daily interest rate
3. Calculate the monthly interest
You can then multiply your daily interest payment by the number of days in the billing cycle to find the amount of interest you owe for the month. Consider using this formula to calculate your monthly interest:
Month's interest = daily interest payment x days in the billing cycle
Most credit card companies give their customers a 21-day grace period to pay off any purchases that they make with their cards. They typically have a minimum repayment dollar amount or use a percentage of the owed balance as the minimum payment per month. You may benefit by making more than the minimum payment toward your bill. If you regularly pay your balance off completely, you can avoid paying interest on any new purchases made during the billing cycle.
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