What does Interest mean on a Loan?

If you have applied for a loan for the first time, then it is important to know that apart from the principal amount, you will also have to pay the interest cost. When you take a loan, by the end of your repayment tenure, you will have to pay a sum that will be slightly more than the principal loan amount that you have borrowed. This extra sum is known as Interest.

So, in layman's terms, Interest means the amount that you pay to your lender. For example, if you take a personal loan of INR 50,000 and you have a repayment tenure of 3 years, then you might have to pay around INR 53,000 or less over your repayment tenure. The extra INR 3000 is the Interest that is charged by the lender. The interest rate levied on the principal amount is based on factors such as your credit score, loan term, loan amount, and current debt (if any). It is charged by the lender as a part of the services offered. It is also a way through which lenders earn profits. The Interest cost will be included in your monthly EMIs, so you won’t have to pay anything separately.

How to Calculate Interest on a Loan

Banks and financial institutes that offer loans consider various approaches when it comes to fixing interest rates. You can also calculate the interest levied on your loan amount. However, sometimes it might seem challenging to do the math as it usually involves the use of formulas.

To make things somewhat smoother for you, we have explained the two common ways that lenders and borrowers usually follow to calculate the interest cost. You can apply the same processes and do the math by yourself to know the interest charged on your loan amount.

Simple Interest Rate Calculation Formula on Loan

The Simple Interest method is an easy method that is sometimes used by the loan provided. It is also sometimes applied to short-term loans. As this formula is easy to use, with the right details on your hand, you can also calculate the interest charged on your loan amount. You can check the formula right below:

Principal Loan Amount x Interest Rate x Repayment Tenure = Interest

So, if your principal loan amount is INR 20000, Interest Rate is 5 percent, and the repayment tenure is 3 years, then you can calculate it as follows:

20000 x .05 x 3 = INR 3000

Here, INR 3000 will be the Interest cost that you will have to pay as an extra amount in addition to your loan amount over a period of 3 years.

Amortizing Loan

Home loans, auto loans, personal loans, and other such types of loans are known as Amortizing loans. The interest on such types of loans is based on the Amortization Schedule. In Amortizing loans, the monthly payments stay fixed, so you must pay the same EMI cost each month until you complete your repayment tenure.

In such loans, when you initially start making your payments, a higher chunk of each payment is forwarded towards the Interest cost. As you come close to paying off your loan, the situation takes a reverse turn. As you move towards the end of your loan, a large portion of your payment is directed towards the principal loan amount than the Interest cost.

If you wish to calculate your Interest cost for an Amortizing loan, then you can use the following method:

Interest Rate/ Number Of Payments x Loan Principal = Interest

  • Number of Payments: Enter the interest rate charged on your loan amount. For example, if the interest rate is 6 percent, enter 0.06.

  • Interest Rate: It means the number of payments that you will make annually. For example, if you are paying monthly, then your Number of Payments will be 12.

  • Loan Principal: Enter your loan amount. This will keep changing after each payment. So, if you are calculating for the first time and you are in the first month of your repayment tenure, then enter the whole principal amount. For example, if your principal loan amount is INR 5000, then your interest cost would be INR 25. If you are halfway through your repayment tenure, then instead of the whole principal amount, put the remaining loan balance.

Once you enter the details, you will be able to calculate your Interest Cost.

If you wish to know the payment that will be directed towards your principal amount in your first month, then deduct the interest from the monthly EMI. For example, if your monthly EMI is INR 400, then deduct 25 from it. So, you will be paying INR 375 towards your principal loan amount.

You can keep repeating this process each month. The only change that you need to apply in the formula is for the Loan Principal Amount. Every time you repay, your original loan principal keeps reducing. So, if you wish to know the Interest rate for every month, then put the remaining loan balance in Loan Principal and do the math.

To understand it better, check the example of an amortization table below for a 6000 INR personal loan with a 7% Interest rate.

Payment Date Starting Balance Repayment Interest Paid Principal Paid New Balance
01/01/2021 6000 500 35 465 5535
02/02/2021 5535 500 32.3 467.7 5067.3
03/03/2021 5067.3 500 30 470 4597.3

Use our Loan Calculator to calculate your total interest paid on your loan amount: Personal Loan Calculator

Factors that Affect Your Interest Rate

There are several factors that affect how much interest you will have to pay. Some of the major variables are explained below:

  • Principal Amount: The principal loan amount or the borrowed sum plays an important role when it comes to paying the interest cost. If the loan amount is high, then you can expect a higher rate of interest.

  • Interest Rate: The interest rate is different from the Interest Cost. The amount that is included in your EMI is the Interest Cost, and the percentage that is fixed by the lender is the Interest Rate. For example, if your interest rate is 7% on a loan amount of INR 6000, then your Interest cost is INR 35. Here, 7% is the interest rate that is fixed by the lender. The higher the interest rate, the higher is the amount that you will have to pay. To ensure a less interest rate, it is important to have a good credit score.

  • Loan Term: A loan term means the amount of time in which you can pay off your loan. For example, if you are qualified for a 7-year loan, your loan term will be 84 months. If you opt for a shorter loan term, then your EMI cost will increase, and your Interest will decrease. If you opt for a longer loan term, then your EMI cost will decrease, and your Interest will increase.

  • Repayment Schedule: There are various ways through which you can make your payments. You can also choose monthly, weekly, and bi-weekly types of payments. The more times you pay, the lesser will be the Interest. If your lender is charging a compounding interest, then paying weekly can save you money. However, before you decide to make weekly payments, do not forget to check your financial habits and spends.

  • Repayment Amount: A repayment amount is an amount that you pay monthly for your loan. If you wish, then you can pay more than the specified amount each month and cut down on your Interest by paying off your borrowed amount before the tenure gets over.