How To Calculate Interest: A Comprehensive Guide

Interest on a loan is a monetary charge that a borrower pays to the lender. Many individuals and businesses borrow money and repay it along with interest as periodic instalments. If you are paying off a loan or want to apply for a loan, prior knowledge of interest rates and related information can help you understand the potential cost of a loan. In this article, we examine the different types of interest and how to calculate interest with a few examples.

What is interest?

Interest or interest fees is the cost of borrowing money from a lender. It is usually a set percentage of the money lent and usually accrues every month. You can avail for a loan for major purchases like a car, home, college education or a home appliance.

When you take a loan, you agree to a payment timeline with the lender and you pay a monthly sum that includes a portion of the loan amount with interest charges. You can develop a strategy to ensure that you make monthly payments until you clear the balance of the loan and its fees. Defaulting on interest payments can attract additional interests and penalties.

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How to calculate interest

Following is a step-by-step guide on how to calculate interest:

1. Learn about different types of interest

A lender and a borrower typically agree on the type of interest before they exchange the principal amount. A lender can charge two types of interest, simple or compound:

Simple interest

Simple interest is an easy method of calculating bank interest on fixed deposits and loans and depends primarily on the principal amount and interest rate. When you make a periodic repayment on a loan, the lender clears all interest due so far and uses the balance amount to calculate new interest. One of the primary advantages of simple interest is that there is no risk of accrual of interest, as it reduces every time you make a repayment. Loans that apply simple interest include:

• automobile loans

• short-term personal loans

• mortgage loans

• consumer loans

• monthly amortisation loans

• student loans

Compound interest

When you borrow money, interest accrues on the money you have yet to pay. The lender clubs the interest that has accrued so far with the principal, on which they calculate interest again. In simpler terms, compound interest specifies an interest rate on the interest amount. A lender calculates compound interest at regular intervals. These loans can follow monthly, quarterly, half-year or annual intervals for calculating interest. Compound interest accelerates the amount payable, as it accrues the interest amount instead of clearing it periodically. Banks, businesses and financial services use compound interest for loans and deposits. These facilities typically operate on compound interest:

• savings accounts

• checking accounts

• fixed deposits

• pension accounts

• credit cards

2. Gather information required to calculate interest

To calculate interest on a loan, it is important that you have appropriate information that helps you to calculate the correct amount. Once you get the required information, you can substitute values into formulae for calculating various types of interest. The amount of interest you pay may depend on the following factors:

• Principal (P): the amount of money follows a monetary format like ₹, $ or £

• Rate (R): the rate of interest per year follows a percentage format like 2%, 5% or 10%

• Time (t): the duration of the loan in years and some cases, months

3. Learn to calculate simple interest

Once you have gathered the information required to calculate interest, you can start calculating interest by learning the appropriate formula. You can use a calculator and a spreadsheet to aid you in calculating interest. The following is the formula for calculating simple interest:

Simple interest (I) = PRt / 100

This formula calculates simple interest I, where P is the principal loan amount you want to borrow, R is the interest rate per period, and t is the term of the loan. The formula indicates that you multiply the loan amounts, interest rate and repayment duration. It is important to note that this formula considers the duration in years.

4. Learn to calculate simple interest when the term is in months

If you borrow money for a short-term for less than one year, you can calculate the simple interest in two simple steps. Follow the same steps for calculating interest for yearly periods and divide the result by 12. The formula to calculate simple interest if the term is in months is:

Simple interest (I) = PRt / (100 x 12)

5. Learn multiple methods to calculate simple interest

If you want to calculate simple interest for a few loans, you can do it using a pencil, paper and a calculator. Online tools help you calculate simple interest if you know the current interest rates and repayment terms. If you want to make professional simple interest reports for large volumes of data at your workplace, you can use spreadsheets to record and process information.

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Example for simple interest calculation

Following is an example for calculating simple interest:

You want to avail of a personal loan of ₹9,00,000 on simple interest. The lender charges a simple interest of 18% per year, and you have agreed to repay the loan in three years. The formula to calculate interest is as follows:

Loan Amount (P) = ₹9,00,000
Interest rate (R) = 18%
Loan term (t) = 3 years or 36 months

Using the formula, you can calculate the simple interest for your loan as:

(9,00,000 x 18 x 3) / 100 = ₹4,86,000

This indicates that the total interest you pay for three years is ₹4,86,000. The total repayment amount or the actual cost of the loan becomes ₹13,86,000. The amount you pay every month as loan repayment would be ₹38,500. To calculate the monthly simple interest, you divide the interest amount by 36:

₹4,86,000 / 36 = ₹13,500 per month

What are the important factors that affect interest calculation?

Interest is a cost that a borrower pays for the privilege of using a lender's money. It is also the profit and source of income for a lender. Lenders denote interest as a percentage of the principal. If you are considering taking a loan, it is important to plan and repay the principal and interest on time. Without a budget or a plan, you may pay interest fees and penalties that can drive up the total value of your loan considerably. If you want to avail a loan, consider these factors that may affect interest calculation:

Principal

Unlike compound interest, simple interest is based on the principal amount. Hence, it is important to know how much you can set apart every month as loan repayment. You can play for weekly, monthly, quarterly, half-yearly or annual repayment. Your frequency of repayment can affect the rate of interest. It is important to plan well and provide repayment, as defaulting can attract additional interest fees and penalties. For example, a default on credit card, car or home loan repayment can attract high penalties for late repayment.

Duration of loan

Long-term loans are usually more expensive as they may have smaller monthly instalments, but high-interest rates. Short-term loans may have higher monthly repayment, but the interest may be low. If your lender charges compound interest, it is always better to increase the frequency of repayments to avoid paying higher interests.

Size of repayments

Loan repayments link to your bank account and banks use this system to avoid delays and penalties. Paying more than the minimum due for loans like a credit card loan, car loan or housing loan can reduce the interest payable. By paying more towards the principal, you can reduce monthly interest. It is good practise to invest additional income into making repayments that can significantly reduce your debt burden in the future.

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What are the different applications of simple interest?

Simple interest is comparatively less expensive for the borrower than loans that apply compound interest. Most instalment schemes for consumer purchases involve simple interest. Car companies create monthly amortisation schedules using simple interest. From the amount you pay every month, a fixed portion goes to repay your principal, and the balance goes towards interest.

As the principal amount keeps reducing every month, the interest payable also reduces. Consumer loans that allow you to procure money for major commercial investments also follow simple interest for calculating monthly dues. Banks use simple interest to calculate interest payable to customers who deposit money at the bank.