Borrowing money is often an expensive transaction, and not only because you have to repay your loan amount.
What really determines the cost of borrowing is the interest you’ll pay throughout the life of your loan. This amount is money you pay for the privilege of borrowing, and it’s money your lender keeps in order to remain profitable and service your loan.
While loan calculators can help you figure out how much interest you’ll pay each month and throughout the life of your loan, understanding how interest on a loan is calculated can still be helpful, as well as reduce the mystery of loan costs. You should also understand the different types of loans available and how interest calculations work differently with each one.
This guide breaks down some basic calculations you can use when calculating loan payments and figuring out how much interest you’ll pay over the long haul.
The first detail you should know and understand is the type of loan you have. With interest-only loans, for example, you’ll only pay the interest on the loan for a specified length of time, and the amount of principal you owe (the amount you borrowed) will stay the same during that period. With this type of loan, figuring out your monthly payment and loan costs is a breeze, and you may not even need any tools to calculate loan payments or long-term interest costs.
For example, let’s say you took out a loan for $20,000 with an annual percentage rate (APR) of 6 percent and a repayment term of 10 years. In that case, you would take the amount you borrowed and multiply it by your interest rate. This figure would represent your annual interest costs, which you would divide by 12 months.