Most of us don’t have tens of thousands of dollars to buy a car or house, so let’s turn to the classic solution: credit. But with credit comes interest.
Don’t worry about the unknown. Understanding simple math or using an online loan calculator can help you determine whether you can afford to take on new debt and pay the interest payments that come with it.
“In order to use other people’s money, they want the certainty that you are paying, and they want to be paid for how their money is used. That’s interest, ”said Nadine Marie Burns, President and CEO of A New Path Financial, an investment advisory firm.
Interest rates involve all sorts of confusing concepts, such as interest rates and amortization. Here’s how interest works, how to calculate it on a loan, and how to get the best interest rates.
What is interest?
Interest, in the simplest sense of the word, is the price you pay for borrowing.
“It’s important to remember that when you factor in the cost of borrowing, the cost of buying the item you want becomes more expensive,” says Burns.
That’s because a lender doesn’t just provide you with the amount you need. For example, if you borrowed $ 15,000 to buy a car, you could end up paying back almost $ 17,000 to the lender if you factor in a 5% interest rate. That $ 2,000 is the cost of borrowing.
Pro tip
Before taking out any loan, do the calculation to make sure you know what your monthly payments will be and how much interest you will end up paying when you are done.
The amount of interest you pay depends on an interest rate the lender decides based on, among other things, the type of loan, your credit history, and your income.
How To Calculate The Interest On A Loan
Before getting a loan, it is important to understand the math behind it. This gives you an overview of your monthly payments as well as the total interest that you will pay over the course of the loan.
But how do you calculate that? There are many free loan calculators online that allow you to enter the loan amount, term, and interest rate – information you should get from your lender – to see your monthly payments and total interest owed.
If you’re curious, here’s how the math breaks down. We focus on an amortized loan, which is a common type of loan that has both principal and interest payments made at the same time. This is what you have for most auto, personal, and home loans. You can use our repayment plan calculator or do the math yourself. (If you’re looking for other types of formulas, such as how to see how much your savings are growing, or how much your mortgage is going to cost you in the long run, take a look at the rest of the calculators on NextAdvisor.)
If you choose the old-school route, get out your pen and paper. You will use this formula and solve for (A) what is your monthly payment including interest. (P) is the principal or loan amount; (r) is the interest rate per period; and (n) is the total number of payments.
A = P {r (1 + r) ^ n} / {(1 + r) ^ n –1}
Let’s calculate this using our previous example of a $ 15,000 auto loan that pays 5% interest over 5 years of monthly payments. (P) would be $ 15,000; (r) would be 0.00416 or 0.05 divided by 12 months; and (n) would be 60 based on 12 payments per year for 5 years.
Then you pocket the numbers and do the math:
15,000 {(0.00416 x 1.00416 ^ 60) / (1.00416 ^ 60 – 1)}
= 15,000 {(0.00416 x 1.282) / (1,282 – 1)}
= 15,000 (0.00533 / 0.282)
= 15,000 (0.0189)
= $ 283.86
That means your monthly loan payment, including interest, is $ 283.86.
Factors That Affect How Much Interest You Pay
There are a handful of important factors that will have the greatest impact on your potential interest rates. You can probably guess it: creditworthiness, debt-to-income ratio, and the total amount of debt you already owe.
“The interest rates offered to a borrower are highly dependent on the borrower’s credit report. Lenders charge higher interest rates from those with poorer creditworthiness. The best interest rates are offered to those with high creditworthiness and low debt-to-income ratios. After all, the lender is taking a risk in letting you use their money, ”said Glenn Downing, Certified Financial Planner and Founder of CameronDowning.
But today, lenders are offering new types of loan products that can accommodate many other aspects of your financial health.
“A lot of these new lenders are literally using thousands of other variables,” says Anuj Nayar, financial health officer at LendingClub.
His company is a prime example: you could look at your bank balances or your monthly cash flow to try and get a lower interest rate, says Nayar.
The loan amount also affects interest rates. The more money you borrow, the higher the risk for the lender, which usually means a higher interest rate for you too. Nayar advises borrowers to think carefully about how much money they really need and try to minimize the loan, which in turn can reduce the amount of interest paid.
How to Get the Best Loan Rates
One of the easiest ways to ensure you are getting the best interest rate is to shop around. Compare loan offers side by side and choose the one that works best for you.
But getting the best personal loan rates actually starts long before you even take out a loan. It is the hard work of improving your financial health and credit score before you need to borrow more money.
“The biggest one is reducing your existing debt,” says Nayar. “The cheapest way to get money is to have money.”
This is because lenders see lower risk with borrowers with lower debt and are willing to offer lower interest rates for that reason.
Another option is to hire a co-signer, someone with a better credit rating, who can vouch for you on the loan application. Remember, however, that if you miss payments, the co-signer will be equally liable for the debt and it could affect their creditworthiness.
Don’t let the mere idea of calculating loan interest rates and delving into algebraic formulas put you off. Understanding how interest rates work is a critical step in making smart credit decisions.
Whether you’re picking up pencil and paper or using one of NextAdvisor’s online calculators, take the time to understand the real cost – including interest – behind your next loan.
