When you borrow money from a bank or other type of lender, you must typically repay the loan back with interest. Interest is the cost of borrowing the money; it's the way lenders make a profit from lending. Interest rates vary, and the way interest is calculated may vary.
Most loans made to consumers use compound interest, although some may use simple interest. Calculating the amount remaining due on a loan can be done manually, but you can also use online calculators, or better yet, contact the lender for an official payoff.
Types of Personal or Consumer Loans
Consumer loans typically fall into one of these categories:
- Car loans
- Home mortgage loans and equity lines of credit
- Credit cards
- Personal loans or debt consolidation loans
- Loans to finance larger purchases, such as appliances
- Medical loans for large, planned expenses, such as orthodontics or surgeries
With the exception of some car loans on promotion, all of these types of loans will charge interest to the borrower at a certain percentage.
What is Loan Interest?
Loan interest is a percentage of the total owed on the loan that is added to the loan balance. The amount actually borrowed, not including interest, is called the principal balance. The principal balance is used to calculate the loan interest. Interest can either be calculated as simple interest, or it can be compounded.
Simple Interest vs. Compound Interest
Loans will charge either simple interest or compound interest. Simple interest means you'll have equal monthly payments for a set amount of time; compound interest means you'll have minimum required payments every month and will pay until paid in full.
How Simple Interest Works
Simple interest is calculated on the principal balance only. For example, if you borrow $10,000 at a 5 percent interest rate, to be paid back within one year, and the lender uses simple interest, the interest will be 5 percent of $10,000, which is $500. If you make monthly payments, they will likely be in equal installments of $875, so that at the end of the year, you will have paid $10,500.
Vehicle loans and mortgage loans are typically made using simple interest. Your monthly payments remain the same every month for the duration of the loan. Your lender will create an amortization schedule, which shows you how each payment will be applied to either principal or interest on the loan.
How Compound Interest Works
Compound interest is more complicated than simple interest and ends up costing the borrower more money. Credit cards use compound interest. Compound interest means you're paying interest on the money you borrowed plus interest on the interest from before. You will have an annual percentage rate, but interest will compound daily or monthly, so your terms will provide a daily or monthly rate charged based upon the APR.
Calculating interest on credit card debt can be quite complex and often like trying to hit a moving target. Your credit card statements will explain how your particular card issuer calculates the interest.
Calculating the Amount Owed Manually
Calculating the amount owed on a simple interest loan is much easier than with compound interest. Typically, with a simple interest loan, you can look up the remaining principal balance (the balance owed not including interest) and multiply that number by the interest rate, then dividing by 365 (or 366 in a leap year) to figure out the daily interest. Calculate the number of days since you last paid on the loan, multiply that by the daily interest and add it to the principal.
So if your principal balance today is $5,000 and your interest rate is 5 percent, your annual interest is $250 (5,000 x .05). $250 divided by 365 days equals daily interest of 68 cents. If you made your last payment 15 days ago, then you need to calculate 15 days of interest, which is 15 x .68, or $10.20. Added to your principal balance, you owe $5,010.20.
With credit card debt, checking your daily balance online is the best way to go. Trying to calculate compound interest manually leaves a big margin for error.
Using an Online Calculator
You can also use online calculators to figure out your balance due. Amortization calculators for mortgages and car payments are abundant online; you may also be able to find calculators for other types of loans. You can plug in the remaining balance, choose the type of interest and the amount and go from there.
Contacting the Lender for a Payoff
The best way to figure out how much you owe on a given day is to contact the lender and ask for a payoff. There may be charges you didn't know about, such as late fees and loan fees, or the lender may calculate the interest in a way that you didn't anticipate. Lenders may require a written request for a payoff, or you may be able to obtain one using your online account.
- Some loans charge a prepayment penalty for paying off the loan before its term is over. Check your loan agreement to see what the prepayment penalty is before you decide to pay the loan in full and close it. If you have a prepayment penalty, you may be better off keeping that loan and using your money to make payments on a different loan that doesn't have a prepayment penalty.
- When you are paying off a loan in full, add five days to the number of days since the last payment when calculating interest owed, because it is unlikely that the payment will be applied immediately. Any extra money will be returned to you.
Rebecca K. McDowell is an attorney focused on debts and finance. She has a B.A. in English and a J.D. She has written finance and tax articles for Zacks and eHow.