Borrowing money is rarely free. Whether you are taking out a personal loan, an auto loan, or using a credit card, the lender charges you for the privilege of using their money. This charge is called interest.
Disclaimer: This guide is for educational purposes only and does not constitute financial advice. Actual loan terms vary by lender.
The Three Components of a Loan
To understand how loan interest is calculated, you need to know the three main parts of any loan:
- Principal: The original amount of money you borrowed.
- Interest Rate: The percentage charged on the principal, usually expressed as an Annual Percentage Rate (APR).
- Term: The amount of time you have to pay the loan back (e.g., 5 years, 36 months).
Simple Interest Loans
Many personal loans and auto loans use a simple interest calculation. This means interest is calculated based only on your current outstanding principal balance.
The formula for daily simple interest is:
Because the interest is calculated on the remaining principal, as you pay down the loan, the amount of interest you pay each month goes down, and the amount of your payment that goes toward the principal goes up (this is known as amortization).
Estimate Your Loan Costs
Use our loan repayment calculator to see how much interest you will pay over the life of your loan.
Loan Repayment CalculatorCompound Interest Loans
Credit cards are the most common example of compound interest loans. With compound interest, the lender charges interest not just on the principal, but also on any accumulated interest from previous periods.
Credit cards usually calculate interest daily. This is why credit card balances can grow very quickly if you only make the minimum payment each month. You end up paying interest on your interest.
How to Reduce the Interest You Pay
- Pay more than the minimum: Any extra money you pay goes straight toward the principal. A smaller principal means less interest is charged next month.
- Pay more often: For loans that calculate interest daily, making half your payment every two weeks instead of a full payment once a month reduces your average daily balance, which slightly lowers your interest charges.
- Refinance: If your credit score improves or market rates drop, you may be able to secure a new loan with a lower interest rate.