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Our handy interest rate calculator helps you work out how much interest you are paying or receiving with just a few easy steps. What’s more, it also shows you the split between interest and principal paid off. If the preceding sentence made little or no sense, then you’ve come to the right place. Keep reading to get a comprehensive understanding of what interest is, including the different kinds there are, which one you should go for, and the factors affecting it. More importantly, we will show you how to calculate interest manually and more efficiently with our user-friendly calculator.
What Is Interest?
Charging interest on money lent is a financial concept almost as old as time itself. The first recorded instance of this happening can be traced a long way back to around 3000 BC (the interest rate charged in this instance was a whopping 20%). Even so, it wasn’t common practice until the 15th and 16th centuries where the Renaissance period saw trade, and along with it, the practice of charging interest, explode. Since then, it has become a widely accepted practice with interest rates going through historical highs (the 1980s) to historical lows (2008-2017). The final months of 2019 saw a general rise in lending rates throughout the United States. But what does it all mean?
To understand what interest is, we must first learn the term ‘principal amount’. This amount is nothing but the total amount you wish to borrow. So, if you take out a $6000 personal loan, the principal amount is $6000. Now, most lenders do not loan out money because they have hearts of gold. They want to earn a profit. This situation is where interest comes in. Lenders calculate a percentage of the principal amount you borrow and add it to your monthly repayments. This percentage is called interest, and it is the price you pay for using someone else’s funds. Now, you must pay back the lender not only the principal amount but also the interest on it.
Though it seems like a Machiavellian act, the practice of charging interest is not all bad. Without it, there wouldn’t be any lenders. Interest allows creditors to not only make a return on their money but also to cushion the inherent risk that comes with lending at the same time. Besides, interest rates are a good reflection of a country’s economy. A healthy or high interest rate is indicative of the fact that business is booming, and the economy is stable. Conversely, a low interest rate showcases an economy in need of some CPR. As can be seen today, the global Coronavirus pandemic is causing interest percentages to take a downward plunge the world over.
Factors Affecting Interest
1. The Principal Amount
As interest is calculated based on the total amount you borrow, and it stands to reason that they are directly proportional. When one increases, so does the other. Since with interest, you end up paying more than you get in hand, it is a good idea to consider the amount you can actually reimburse and not just the amount you need before taking out a loan.
2. The Loan Period
In other words, how long have you taken out the loan? Typically, if you take out a short-term loan (described as a loan that is paid off within a year), you will face higher interest rates than a long-term loan. Is it any wonder then that the incident mentioned above of the exorbitantly charged interest rate from 3000 BC was for a short-term loan? That said, the overall amount of interest you end up paying with a short-term loan is less as the number of payments is also less. Before committing to a short-term loan, though, it is prudent first to scrutinize your financial ability to take it on.
3. The Interest rate
The higher your interest rate, the more you pay. This rate, of course, differs from lender to lender. Helpfully, the government sets legal limits that prevent private lenders from charging exorbitantly high rates. Federal loans typically have a lower interest rate than those offered by private lenders.
4. The Repayment Schedule
Another factor that affects how much interest you pay overall is your repayment schedule. As you chip away at the loan amount, making it smaller and smaller, your interest amount goes down correspondingly too. So, the more repayments you make, the lesser the interest is. While most loans follow a monthly payment schedule, some allow weekly, biweekly, or fortnightly schedules.
Types Of Interest And How To Calculate Them
There are two main types of interest: Simple interest and compound interest. Both work the same way whether you borrow or lend money.
As its name implies, a simple interest loan is a straightforward affair where you pay or receive interest on the principal amount. This form of interest is the more common of the two and is widely applied to personal, car, home, and student loans. They have an amortization schedule, typically, a monthly payment schedule established to pay off both the principal and interest amounts.
Here is the formula for calculating simple interest:
Simple Interest = PA x r x n
– PA is the principal amount
– r is the interest rate
– n is the duration of the loan in years
Joanna has taken out a simple interest student loan of $20,000 at an interest rate of 6%. She took three years to pay off the loan. Applying the formula, we get:
$20,000 x 0.06 x 3 = $3600
So, by the time Joanna pays off her student loan, she will have paid an extra $3600 in interest fees.
The word compound is used to show something that has two or more elements. Accordingly, in compound interest, you have two kinds of interest rates going on. As with simple interest, the first is the interest on the principal amount. The second, and this is where compound interest goes one step further, is the interest on the interest itself. This double whammy of interest rates is mostly seen with credit card loans. It is why financial experts advise getting rid of credit card dues as soon as possible as they cause your debt to grow exponentially. The only time compound interest works in your favor is when you invest money somewhere, like in a high-interest savings account.
The formula for calculating compound interest is:
Compound Interest = PA x (1 + r) n – PA
Let us stick with the example of Joanna and her student loan. Only this time, her loan of $20,000 is one that compounds annually at the rate of 6%. She still manages to pay it off in 3 years. Applying the compound interest formula, we get:
$20,000 x (1 + 0.06)3 – $20,000 = $3820.32
As you can see, the overall interest she paid is higher in the case of a compound interest loan.
How To Check Monthly Payment Splits Between Interest & Principal
If you want to get a breakdown of how much of your interest and principal amounts are being paid off each month, you need to make a series of calculations.
– First, you will need to find out how much of the interest you are paying off monthly. The formula for that is:
Interest Paid Monthly = interest rate/total number of installments x Principal Amount.
– Second, to get how much of the principal amount you are paying off monthly, simply subtract the above result from the monthly installment amount:
Principal Paid Monthly = Monthly installment – Interest Paid Monthly
– Lastly, reduce the monthly principal amount from the beginning balance, and you will have a new balance that reflects the total amount paid off from your loan.
New Balance = PA (or beginning balance) – Monthly Principal Amount
– Simply rerun the steps to get a monthly-wise breakdown of your interest and principal payments.
Suppose you have taken out a mortgage of $100,000 at an interest rate of 13% payable over 30 years. If we build a table for the first six months using the above steps, it will look like this:
Notably, the interest payments are decreasing, and payments towards principal are going up every month. You need to repeat this 360 times to get a complete breakdown of your payment towards interest and principal amount over 30 years.
How To Use Our Interest Rate Calculator
As you can see, the above calculations are quite time-consuming and complicated. A more straightforward bet would be just to use our interest rate calculator. It is easy to use and will give you the results in a jiffy.
Here is what you need to do:
Step 1: Input the loan amount. This amount can be the principal you first start with or the remaining balance after you have made a few payments
Step 2: Enter the loan term. The loan term simply corresponds to the period of your loan measured in years.
Step 3: Now, put in the monthly payment (also known as EMI) amount.
Step 4: Finally, hit calculate, and you will have your interest amount in a few moments.
Interest rates are a pivotal financial tactic that helps both lenders and borrowers. With our interest rate calculations, there is no need to do any complicated calculations. Use it to work out this critical metric quickly.