Borrowing money from the bank isn’t free. Depending on your credit profile, it can be downright expensive. The best personal loans advertise a wide range of interest rates. But precisely how is interest on a personal loan calculated? And how can you lower the interest you pay?
Here’s what you need to know about how interest on a personal loan is calculated and how to save money when borrowing is unavoidable.
What is personal loan interest and how does it work?
When you open a personal loan, you’ll be enrolled in a payment plan with equal monthly installments until the loan term ends. This monthly payment consists of two things: principal and interest.
In other words, the interest you pay is baked into your payment plan. It’s unavoidable; a portion of each monthly payment will be dedicated to paying your lender for the privilege of borrowing money.
Amortized interest vs. simple interest
There are two general ways that a lender will calculate the interest you earn.
Amortized interest is calculated based on the amount of money you owe each month. The nature of amortized interest means you’ll pay the most interest at the beginning of your loan. As you pay down what you owe, the interest portion of your monthly payment will also decrease.
For example, a five-year loan of $10,000 with a 10% interest rate might result in a monthly payment of $212.47, broken down as follows in the first two months:
- First month: $129.14 in principal and $83.33 in interest
- Second month: $130.21 in principal and $82.26 in interest
As you can see, your principal payment slowly increases as your interest payment decreases. By the time you pay off your loan, you’ll have coughed up around $2,748.20 in interest in the example above.
Simple interest is less common. You’ll be given a flat interest rate upon account opening with a payment breakdown that doesn’t change as you reduce your principal. To use the same example as above, your five-year $10,000 loan at 10% would be assigned $1,000 per year over five years. You’d pay $15,000 with $250 monthly payments:
- First month: $166.66 in principal and $83.33 in interest
- Second month: $166.66 in principal and $83.33 in interest
With all else being equal, simple interest is the more expensive way to borrow money.
Again, no matter which interest structure your lender uses, your monthly payment will not change throughout the life of your loan.
APR vs. interest rate: What’s the difference
Interest and APR (Annual Percentage Rate) are often used interchangeably—but there’s a slight distinction you should know.
Your interest rate is a fixed percentage of the amount of money you’ve borrowed. APR includes this percentage, but it also includes any other fees associated with your loan that are included in your monthly payment (think origination fees, administrative fees, etc.). Your APR gives you the full picture of what you’re paying for your loan.
As an example, your interest rate may be 9.5%, but your interest may be 10% after fees. Before you open a loan, you’ll be shown the APR you can expect to pay.
How to calculate your personal loan interest
To calculate the interest you’ll pay on a personal loan, you’ll first need to know if you’ll be paying amortized or simple interest. In almost every case, your personal loan will be subject to amortized interest.
Many websites offer straightforward loan interest calculators that allow you to quickly enter your loan details and receive a report of the interest you’ll pay. But the mathematical formula itself isn’t complicated:
(Monthly payment × number of payments) − principal = Interest paid
With the aforementioned five-year loan of $10,000 at 10% APR (assuming your APR is the same as your interest rate), the formula would be: ($212.47 x 60 total payments) – $10,000 = $2,748.20.
Factors that affect your interest rate
Your interest rate is assigned based on multiple factors, most of which are related to your creditworthiness and ability to repay your loan. These include:
- Credit profile: Generally speaking, the higher your credit score, the more trustworthy you are as a borrower. The least risky borrowers tend to get the lowest interest rates.
- Debt-to-income ratio: Your DTI is the amount of your monthly income that is used to repay your current debts. Credit card balances, outstanding personal loans, auto loans, etc. count toward your DTI. Lenders examine this metric to decide if you can afford another monthly payment.
- Loan terms: The length of your loan can affect your interest rate.
- Loan type: You may also find that a lender will offer different interest rate ranges based on what you plan to use the loan for. A debt consolidation loan and a home improvement loan may have varying ranges.
Of course, actions by the Federal Reserve also dramatically affect your interest rate. When it sets the federal funds rate, it influences lending rates across the entire economy. Lenders typically increase rates when the Fed raises its rate, and they tend to lower rates when the Fed drops its rate.
How to get a lower interest rate
Based on the above factors, there are a few practical steps you can take to give yourself the best chance at a lower interest rate. Again, it’s all about making yourself as safe of a customer as possible:
- Improve your credit score: Focus on a low credit utilization ratio and on-time payments. These are the two most important elements of your credit score. Also avoid opening and closing accounts regularly.
- Lower your DTI: A good rule of thumb is to keep your debt-to-income ratio at or below 40%. This means either decreasing your current debt or increasing your income—or both.
- Apply for a smaller loan: If you borrow less money, you’re less risky to the lender. This may result in lower interest rates.
- Go with a shorter repayment term: Similar to applying for a smaller loan amount, lenders view short repayment plans as lower-risk. You may be rewarded for committing to higher monthly payments with a lower interest rate.
- Open a secured loan: Secured loans tend to come with lower interest rates because they are backed with collateral (jewelry, automobile, etc.). The lender may be willing to drop your interest rate because it knows that if you default on your loan, it can use your collateral to repay itself.
- Use a cosigner: When you add a cosigner to your loan application, the bank will consider both of your credit profiles. Applying with someone that has better credit than you can lower your interest rate. Just note that your cosigner is ultimately on the hook for repaying your loan if you don’t. Defaulting on the loan will tank both your credit scores.
The takeaway
Interest on a personal loan is most commonly amortized, meaning your interest is re-calculated each month according to your outstanding loan balance after your most recent payment. You can lower your interest rate by improving your credit score, lowering your debt-to-income ratio, using a cosigner, or offering collateral with a secured loan.
Frequently asked questions
What is an amortization schedule and how does it work?
An amortization schedule shows you how much you’ll pay each month in principal and interest on a personal loan. Your monthly payments stay the same, but the amount you pay in interest slowly declines as you lower your principal.
How does my credit score affect my personal loan interest rate?
Your credit score can greatly affect your personal loan interest rate. Put simply, your credit score reflects your creditworthiness as a borrower. The higher it is, the more a lender can (theoretically) trust you. The most trustworthy borrowers tend to get the lowest interest rates.
What is a prepayment penalty on a personal loan?
A prepayment penalty is a fee for repaying your personal loan before it’s scheduled to end. Paying your loan off early results in the bank earning less interest—so they tack on a fee.
What factors affect my personal loan interest rate?
Factors such as your credit score, debt-to-income ratio, repayment length, and type of loan can all affect your personal loan interest rate.
What is the difference between APR and interest rate on a personal loan?
The difference between APR and interest rate on a personal loan comes down to fees. An interest rate is simply the percentage of your loan that a financial institution will charge you to borrow money. APR is this unique interest rate plus any other fees associated with the loan, such as an origination fee, that is baked into your monthly payments. In other words, the APR is usually higher than the interest rate.
