The interest rate on a personal loan — also called the annual percentage rate (APR) — determines how much you’ll pay the lender on top of the amount you borrow. Depending on the borrower and the lender, APRs can range wildly, from as low as 5% to as high as 200%. However, your rate will depend on your creditworthiness and how the lender evaluates applicants. But how does interest work, and how can you calculate your interest payments?
How interest works
Interest is the amount a lender charges you to borrow a sum of money. Lenders typically have a range of interest rates, and the rate you get depends on your credit score, finances and any other factors the lender considers. The cost of a loan, including interest and fees, is rolled up into what is called the annual percentage rate (APR). The APR expresses the percentage of the total amount borrowed that is owed each year. Hence, the lower your APR, the less you will pay.
However, the longer you borrow money, the more you will pay in interest because you are making payments to the principal and interest each month. For example, if you borrowed $10,000 for one year at a 5% APR, you would pay $272 in interest overall, through 12 payments of $856. However, if your loan term was five years, you would pay $1,340 in interest overall, in 60 payments of $189. The longer-term loan offers a smaller monthly payment but costs much more in the long run. Try to get the lowest APR available and then find the right balance between an affordable monthly payment amount and a low overall cost.
How to calculate interest rates
Most personal loans are amortized with a fixed interest rate, expressed as an APR. An amortized loan means the lender works out a schedule of repayment where the monthly payment amount stays the same but the interest is based on the unpaid principal balance at the beginning of the month. Each month, you pay less towards interest and more towards the principal due to the declining principal balance.
To calculate the amount of interest due for your first month, divide your APR by the number of payments in the year. Then, multiply that by the loan principal to get the interest due.
(APR/payments per year) x principal loan balance = interest
For example, if your loan amount is $10,000, your loan term is five years and your APR is 5%, the equation would be:
(0.05/12) x $10,000 = $41.67
In the following months, subtract the interest paid the prior month from the repayment amount to get the amount you paid to the principal.
Total payment amount – interest paid = Amount paid toward the principal balance
Using the example above, the payment amount would be $188.71 so the equation would be:
$188.71 – $41.67 = $147.05
Then, subtract the amount that was paid to the principal from the total principal amount to get your new balance for the second month.
$10,000 – $147.05 = $9,852.95
The new balance can then be added into the first equation to get the next month’s interest payment.
(0.05/12) x $9,852.95 = $41.05
Using these equations, you can calculate out your entire amortization schedule by hand. However, you can do this much more easily using a personal loan calculator online.
Most personal loans are calculated based on simple interest so you only pay interest on the principal amount. Additionally, lenders may offer fixed or variable interest rates. Fixed rates will remain the same throughout the term of your loan while variable rates will adjust periodically. Which is better depends on you. Variable rates often start lower than fixed rates but can go up over time so fixed rates offer more predictability. The better choice will depend on your tolerance for risk, your preferences, and the length of your loan.
What affects interest rates
The interest rate offered to you is the result of many factors at play, both personal and impersonal. Each lender has criteria it uses to evaluate applicants which include factors such as credit score, loan amount, loan term, the presence of collateral and your financial situation. Lenders also set minimum and maximum APR ranges. These ranges are based on the lender’s individual discretion (which can be impacted by the credit score range they target and whether they are an online bank or not) and on the federal funds rate set by the Federal Reserve.
The federal funds rate is the rate the Federal Reserve charges to lend money to banks so it impacts their profit margins. As a result, when the federal rate decreases, we often see a decrease in rates offered by lenders and vice versa. But why do the federal rates change? The Federal Reserve adjusts the rate in an effort to maintain stability in the economy so when the economy is thriving, the rate usually increases and when it is struggling, the rate decreases.
When shopping around for a personal loan, it’s important to understand how the interest works. In most cases, the interest charges will be the primary cost you pay to borrow the money, so you want to make sure you choose a lender that offers you a competitive deal. While it’s helpful to understand how interest is calculated by hand, online personal loan calculators make life much easier. You can enter the basic loan terms and, in seconds, get the full break down of the payments over the life of the loan. Then, you can easily compare the monthly payment amount and total cost of the loan of each potential lender side-by-side.
Remember that to get the best rates, you need to shop around because the APRs offered to you will vary greatly from one lender to the next. Additionally, make sure your credit reports are accurate and finances are in order so you can get the lowest rate possible. Moreover, when you hear the federal rate is dropping, it may be a good time to get a loan or consider refinancing existing loans.