How to calculate interest on a loan

If you understand how the interest on a loan is calculated this can help you to manage your repayments and potentially save you money.

Interest is the amount charged by a financial institution to let you borrow money. As a borrower, you’re charged interest regularly throughout the life of the loan. Interest is typically shown as an annual percentage rate, or per annum, but is actually charged on a more frequent basis.

How is interest calculated on a loan?

Interest on a loan, such as a car, personal or home loan, is usually calculated daily based on the unpaid balance of your loan.

This typically involves multiplying your loan balance by your interest rate and dividing this by the 365 days in a year. This shows your daily interest charge. As interest is usually charged monthly, the daily interest amount is then multiplied by the number of days in the month.

As a hypothetical example, if you had a home loan balance of $400,000 at 5.00% p.a. (based on a borrower with an LVR of 80%, comparison rates vary depending on the product), your monthly interest charge would be:

• $400,000 x 0.05 / 365 = $54.79 daily interest (rounded out)
• $54.79 x 31 days in May (this month, for example) = $1,698.49 interest for May

Keep in mind that your loan may be calculated in a different way depending on who you bank with.

The amount you’ll usually be required to repay each period will be more than just the interest alone (unless you have an interest-only home loan) as you’ll need to repay towards both the amount you borrowed and any interest. That’s based on a much more complicated formula so check with your lender to see how that works.

To get an estimate of how much you’ll need to repay, including the interest over the life of a loan, you can use Canstar’s calculators for:

• Mortgage repayments
• Vehicle loan repayments
• Personal loan repayments

If you choose to pay more than the minimum repayment required, or if you choose to pay more frequently such as weekly or fortnightly, then you can make savings on your loan. You can use Canstar’s extra home loan repayments calculator to see how making extra repayments could save you time and interest on your home loan.

What can impact the interest amount on a loan?

The main factors that can influence how much interest you’ll pay on a loan include the interest rate, the loan amount, the term or life of the loan and the frequency of payments. So let’s take a close look at each and any other factors that can affect how much interest you pay on a loan.

1. The interest rate

A loan’s interest rate can have a big impact on the total amount of interest you pay.

For example, according to Canstar’s mortgage calculator, on a $400,000 loan with an interest rate of 5.00% p.a., monthly principal and interest repayments and a loan term of 30 years, the total interest payable will be $373,023.

By comparison, if the interest rate was one percentage point lower – say 4.00% p.a. – the total interest payable would be significantly less at $287,478, a saving of $85,545. If the interest rate was one point higher at 6.00% then the interest payable would be $463,353, an extra $90,330.

Interest rates can rise and fall over the duration of a variable rate loan. With a fixed rate loan, the rate remains the same for a set period of time.

Some of the factors that can determine the interest rate you would pay on a loan include:

• Your credit history and credit score
• Whether the loan is fixed or variable
• For home loans, what the loan-to-value ratio (LVR) is (in other words, how much of a deposit you have)
• The loan purpose – for example whether it’s for a home to live in or an investment property
• For personal loans, whether the loan is secured or unsecured

You can compare a range of home loan, car loan and personal loan products using Canstar’s comparison tables. You can sort these tables by interest rate and comparison rate to see what different lenders are offering.

Remember, a loan’s interest rate is different to its comparison rate. A comparison rate combines the loan’s interest rate plus most fees and charges and is designed to give you a closer estimate of the total cost of a loan per year.

2. The loan amount

The more money you borrow, the more interest you will generally pay. This is because interest is calculated as a percentage of your loan balance.

Taking the hypothetical example above, if you were able to take out a $300,000 loan at a 5.00% p.a. interest rate rather than a $400,000 loan, you would pay $279,767 interest over the life of the loan, a saving of $93,256 in interest.

3. The loan term

The longer the term of your loan, the more interest you’ll pay. For example, if you paid off the hypothetical $400,000 loan above at a 5.00% p.a. interest rate over 25 years rather than 30 years, you’d pay $301,508 in interest, a savings of $71,515 in interest.

4. The repayment frequency

How often you make repayments can impact the interest payable. This is because interest is usually calculated on a daily basis.

If you make more regular repayments (for example, weekly or fortnightly instead of monthly), you’ll be paying more of the principal amount more frequently and the balance that your interest is calculated on will be lower.

5. The number of days in a month

The number of days in the month can impact your repayment amount. Interest is usually calculated daily, so your interest repayments will typically be slightly higher for a 31-day month compared to a 30-day month, or even a 28(9) day February.

Other factors, such as whether you make additional repayments or whether you use a mortgage offset account, can impact the amount of interest payable. If you make interest-only repayments for a period of time, this will generally increase the interest you pay in the long run. This is because you won’t be paying down the principal amount during this time.

By budgeting and managing your finances carefully, you may be able to cut expenses from elsewhere and use the money saved to reduce your loan amount (if your loan allows you to make extra repayments). This would reduce the amount of interest you pay.

Canstar’s Budget Planner Calculator may help you to plan for your expenses. Depending on your personal circumstances and the type of loan you’re looking for, you may also like to view Canstar’s Award winners for:

• Home loans
• Personal and car loans

Make sure you read any relevant documents such as any Target Market Determination (TMD) or Key Facts Sheet (KFS) when deciding if a loan is suitable to your needs and your pocket.

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