When a borrower receives a loan, a promissory note may document the agreement. As a signed promise to repay the loan at a specific time, the promissory note may also include interest that will be due with repayment. Calculate interest on a promissory note with a basic formula that includes the principal amount, the interest rate and the time period of the loan.
TL;DR (Too Long; Didn't Read)
The historic method of daily interest calculation involved dividing by 360 instead of 365, based on 12 30-day months. Most financial institutions today utilize the 365- or 366-day interest calculation method.
Review the Promissory Note's Terms
Read the promissory note to find the relevant information required to calculate the interest. Determine the principal amount of the loan, the interest rate and the time of the loan – expressed in either years, months or days. The promissory note may also state whether the interest will be calculated as simple interest or as compound interest, otherwise known as amortized interest.
Calculating Simple Interest
If interest on your loan is calculated as simple interest, the formula for calculating interest begins with the total principal balance multiplied by the interest rate. For example, if the principal is $5,000 and the interest rate is 15 percent, multiply 5,000 by 0.15 to equal 750.
Next, you account for the time period. If your loan is for a period of years, multiply the product of principal times interest by the number of years. Thus, if the example set forth above is for a three-year promissory note, multiply 750 by three years to equal 2,250 in total interest. If the loan is for a period of months, divide the number of months by 12 to determine the time multiplier. For example, for a nine-month promissory note, divide 9 by 12 (the number of months in a year) to equal 0.75. Multiply 750 by 0.75 to equal 562.50. Likewise, for a daily time period, multiply the product by the ratio of days to years. For example, for a 90-day promissory note, divide 90 by 365 (the number of days in a year) to equal 0.25. Multiply 750 by 0.25 to equal 187.50.
Calculating Compound Interest
Interest for some loans, particularly mortgage loans, is amortized instead of calculated on a simple basis. Amortized interest is also called compound interest, and the interest is calculated not only on the principal balance but also on the accumulated interest from previous periods. Compound interest uses a more complicated formula: You must add 1 to the interest rate (for example, a 5 percent interest rate would mean 1 + 0.05 = 1.05) and then raise the total to the power of whatever the number of periods is for repayment. So if the loan is a three-year loan with a 5 percent interest rate, you would need to add 1 + 0.05 = 1.05, and then calculate 1.05 to the third power, which is 1.157625.
Multiply that result by the loan's principal balance. So if the loan as set forth above (5 percent interest to be paid over three years) has a $10,000 principal balance, you would multiple $10,000 by 1.157625 to arrive at 11,576.25. Then you subtract the principal balance of $10,000 from that figure to arrive at $1,576.25 in total interest.
- The historic method of daily interest calculation involved dividing by 360 instead of 365, based on 12 30-day months. Most financial institutions today utilize the 365- or 366-day interest calculation method.