How Interest Calculated?
Pankaj Singh
| 28-12-2024
· News team
Understanding how banks calculate interest on your home loan can help you make informed decisions about borrowing and repayment.
Here’s a breakdown of the process and key concepts to grasp.
Principal and Interest
Principal
The principal is the amount you borrow from the bank. For instance, if you buy a house for $500,000 and pay $100,000 as a down payment, the remaining $400,000 is the principal.
Interest
Interest is the fee banks charge for lending you money. It’s calculated as a percentage of the principal. Depending on the loan type, the calculation can vary. Short-term loans often use simple interest, while long-term loans like mortgages typically use amortized interest.
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Types of Interest Calculations
Simple Interest
In simple interest, the formula is straightforward:
SI = P × R × T
P = Principal
R = Annual interest rate
T = Loan term in years
For example, if you borrow $200,000 at a 5% annual interest rate for 10 years, the total interest is:
$200,000 × 0.05 × 10 = $100,000
Amortized Loans
Mortgages often use amortization, where the monthly payment remains the same, but the portion allocated to principal and interest changes over time. Initially, you pay more interest, but as the principal decreases, the interest component of each payment reduces.
Example: Mortgage Interest Calculation
Dear Lykkers, let’s consider a $300,000 mortgage with a 30-year term and a 4% annual interest rate. The monthly interest rate is:
4% ÷ 12 = 0.333%
In the first month, the interest is:
$300,000 × 0.00333 = $1,000
If the total monthly payment is $1,432.25, the remaining $432.25 goes toward the principal. As you pay down the principal, the interest component of your payment reduces.
Adjustable-Rate Mortgages (ARMs)
With ARMs, the interest rate adjusts after a fixed period, potentially increasing your payments. Initially, ARMs might offer a lower rate, but post-reset, the rate adjusts to market conditions, which could raise your monthly payment.
Interest Rate vs. Annual Percentage Rate (APR)
The APR provides a more comprehensive picture of loan costs by including fees like mortgage insurance, discount points, and closing costs. It’s typically higher than the interest rate but is crucial for comparing loan offers.
How Principal & Interest Are Applied In Loan Payments | Explained With Example
Video by Real Estate Finance Academy
The Bottom Line
Understanding how your payments are divided between principal and interest can help you plan better. While online calculators are a convenient option, knowing the basics of interest calculation empowers you to evaluate loans more effectively and manage your finances confidently.