You often borrow money when you require some funds for a specific period. In such a situation, the lenders will expect to get something in return for the risk taken by them by lending you their money. It means you have to pay a specific amount in addition to the borrowed amount to the lender. That additional amount is termed as interest, whereas the borrowed amount is known as the principal amount. Lenders like SoFi earn their profit in part, and a specific formula calculates that interest. Let’s see how you can calculate the loan interest when you borrow money.
What Is Interest?
Before going into the formula for calculating the loan interest, let’s first discuss the part. Interest is the amount you pay when you borrow money from someone else.
If you borrow a personal loan of $100,000 and agree to pay a total of $105,000 to the lender for the next five years, this additional $5000 is the interest.
When you repay the loan over time, a specific portion of that paying goes toward interest, and the remaining amount goes towards the borrowed total. The interest rate you pay depends on several factors, like your income, credit history, loan terms, and loan amount.
What Is The Formula For Calculating Interest On A Loan?
Lenders use different approaches to calculate loan interest based on the loan type. To help you understand loan interest calculation, we will discuss the simple interest method. You can easily calculate interest on your loan using this method if you have complete information.
Formula
Interest = Principal loan amount * Interest rate * Time
First, collect information like principal loan amount, time (number of years or months to repay the loan), and interest rate. Let’s take an example to understand the formula and to calculate the loan interest.
Suppose the principal loan amount is $100,000 at a 5% interest rate for five years. The equation for your interest looks as follows.
Interest= $100,000 * 0.05 * 5 = $25,000
This sum is the amount of interest for five years. To calculate monthly interest on a loan, divide this amount by 60.
Monthly interest on a loan = $25000/60 = $417
Amortizing Loans
Most lenders use the amortization method to charge interest on a loan. Mortgages, auto loans, and student loans often fall into this category. As per this method, the monthly payments remain fixed, and the repayment of a loan performs in equal installments. Here the lender changes the borrower’s payments to the loan balance over time. The initial monthly payments are usually interest-heavy. It means a significant portion of initial paying goes toward paying the interest amount each month. But as the borrower gets close to the loan payoff date, the application of payments turns. The central portion of the amount goes toward the principal balance while less towards interest cost.
Calculate The Interest Amount
Let’s calculate the interest amount according to an amortizing method.
- Divide the number of payments you will make each year with the interest rate. If the payings per year are 12 and the interest rate is 5%, you will divide 0.05 by 12 to get 0.004.
- Now, multiply 0.004 by the remaining loan balance for determining the interest amount that month. If your loan balance is $10,000, then the first month’s interest will be $40.
- Subtract the monthly interest from the fixed monthly payment to know how much you pay for the principal in the 1st month. If the lender has set the monthly payment at $540, then $500 will count towards the first month’s principal. The lender will subtract that amount from the outstanding balance.
- Next month, replicate the new leftover loan balance procedure and keep repeating it every subsequent month.
What Is EMI, And How Is It Calculated?
EMI is the most important word associated with loans. It stands for equal monthly installments that refer to the loan’s monthly payments.
These payments consist of contributions towards both interest and principal on the loan amount.
During the initial stages, the central part of EMI payments is the interest. As the years’ pass, the proportion of interest repayment decreases, and principal repayment rises.
The loan amortization schedule shows the tabular presentation of a loan along with its EMI payment. It represents the division between the principal component and the interest component of a specific EMI payment. That schedule helps the investor examine how much you already paid and how much the loan stands out. It includes payment period, EMI, principal payment, outstanding loan, and interest. This schedule will help the bearer if he desires to refinance the loan or desire to foreclose his loan.
Factors Influencing EMI
Three factors produce the Equated Monthly Installment of the loan.
- Loan amount: It is the borrowed amount.
- Interest rate: The rate you calculate the interest on the borrowed amount.
- Loan tenure: It is the time duration during which the borrower repays the loan.
Calculation Of EMI
The formula for calculating EMI is as follows.
EMI = P*r*(1+r) / ((1+r)n-1)
Where P = loan amount, n = tenure in months, r = interest rate
For example, if the principal amount is $100,000, the interest rate is 10%, and tenure is 12 months, then EMI will be:
EMI = 100,000*0.1*(1+0.1)/((1+0.1)12-1)
EMI = $8792
The Bottom Line
Based on the above formula, you can see that the interest rate and loan amount are directly proportional to the loan tenure. The higher the interest rate or loan amount, the higher the EMI payments will be. On the other hand, the EMI payments will reduce if the loan tenure increase. Another critical factor that affects an EMI payment is the interest type on loan. Like a fixed-term loan, the EMI payment remains constant throughout the tenure. The interest rate varies as per the current market rates for a floating rate loan. Therefore, the EMI payment also alters.
