How to calculate interest on a loan

How to calculate interest on a loan

Interest is the amount charged by a financial institution on money borrowed. Interest on a loan, such as a car, personal or home loan, is usually calculated daily based on the unpaid balance. This typically involves multiplying your loan balance by your interest rate and then dividing this amount by 365 days (a regular 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.

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 (the most common length of a month) = $1,698.49 interest

Keep in mind that your loan may be calculated in a different way depending on your lender. 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 also need to make payments towards the amount you borrowed (the principal).

To get an estimate on 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.

Compare Home Loans

What can impact the interest amount 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. with monthly principal and interest repayments and a loan term of 30 years, the total interest payable will be $373,023 over the life of the loan.

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 a loan’s interest rate include:

• Your credit history and credit score.
• Whether the loan’s interest is at a fixed rate or variable rate.
• What the loan-to-value ratio (LVR) is (for home loans specifically).
• The loan purpose – for example whether it’s for a home to live in or an investment property.
• Whether the loan is secured or unsecured (if it’s a personal loan).

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. These can also be accessed via the Canstar app.

Remember, a loan’s interest rate is different to its comparison rate. While the interest rate tells you how much you’ll be charged to borrow money, it doesn’t include many of the extra costs that can come with a loan. 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 $400,000, 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.

That’s a potential saving of $71,515 in interest, simply by shortening the loan term. While shorter terms mean higher monthly repayments, they can significantly reduce the total cost of your loan.

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

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 (or 29)-day February.

Other factors, such as whether you make additional repayments or whether you use a mortgage redraw or 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.

How to get the best loan interest rates?

To increase your chances of getting a favourable interest rate from a lender, there are a few things you can consider doing:

• Improve your credit score: Lenders will generally offer more competitive rates for borrowers with higher credit scores. This applies to most loan types, such as home, personal, car and business loans. You can check your current credit score for free with Canstar and via the Canstar app.
• Reduce your debt-to-income ratio: A debt-to-income ratio compares the amount of debt you have (e.g. home loans, money owing on credit cards, HECS/HELP loans etc.) to your overall income. If you have a large amount of debt, lenders may see you as a more risky borrower, when compared to someone with minimal outstanding debts. Lenders will typically use your debt-to-income ratio when assessing your loan application and it may impact the overall interest rate that they offer you.
• Choose a shorter loan term period: The general rule is that the shorter the loan term, the less interest you will have to pay. It’s important to keep in mind that if you opt for a shorter loan term, your repayments will be higher.
• Compare different lenders and their products: It’s often worth comparing different lenders and their loan products to see which one suits your needs and situation the best. You can compare a range of different lenders and products for home loans, car loans and personal loans using Canstar’s comparison tables.

Budgeting and managing your finances carefully may also allow you to cut back on unnecessary expenses 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 overall.

Canstar’s Budget Planner Calculator or the budgeting related content on the Canstar app may help you plan out 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 the Product Disclosure Statement (PDS), Target Market Determination (TMD) or Key Facts Sheet (KFS) when deciding if a loan is suitable for your needs and situation.

How to calculate interest on a loan that uses an amortisation schedule

For more complex types of loans, like car, home and business loans, your repayment structure may be subject to an amortisation schedule. This means the part of your repayment that goes towards interest decreases over time and the part that goes towards the principal increases.

The monthly repayments on these amortising loans are fixed, with the loan being paid over time in equal instalments. The interest charged by the lender, however, changes over time. Initial payments for amortising loans are typically interest-heavy, meaning a smaller portion of your repayment goes towards the principal balance itself. As the loan term progresses and you come closer to paying off the loan, your lender puts most of your repayment towards your principal and less towards interest fees.

Amortisation can be calculated by multiplying the loan amount by the interest rate. Divide that result by 12 to get the amount of interest paid monthly, then subtract that from the monthly payment. Whatever remains goes toward the principal.

Example: a home loan of $800,000 with an interest rate of 6% and monthly repayments of $5,000.

In the first month

$800,000 x 6% = total interest of $48,000

$48,000 divided by 12 = monthly interest of $4,000

$5,000 – $4,000 = $1,000 put toward the principal

In the second month

$799,000 x 6% = total interest of $47,940

$47,940 divided by 12 = monthly interest of $3,995

$5,000 – $3,995 = $1,005 put towards the principal

In the third month

$797,995 x 6% = total interest of $47,879.70

$47,879.70 divided by 12 = monthly interest of $3,989.98

$5,000 – $3,989.98 = $1010.02 put towards the principal

While the initial difference is small, as the months go on, the principal amount steadily decreases and a smaller proportion of the repayment goes toward interest.

Lenders benefit from amortised interest loans, as the bulk of your interest payments are made in the beginning of the loan term. This means that the savings from paying off a loan early may be limited—unless your loan includes features like an offset account or allows extra repayments. These features can help reduce the total interest paid and potentially shorten your loan term.

Compare home loans with offset accounts