The nitty-gritty of loan repayment is still an unfamiliar matter to most individuals.
When we borrow money, we are expected to repay the amount over a certain period. However, loan repayment is a more complex deal than that.
The process is stratified and sometimes contingent on a number of factors, such as the lender and the loan type. Knowing all the factors which influence repayment can help us make informed decisions and cut down on the additional amount we pay as interest.
In this article, we will learn what interest levied on a loan refers to, how to calculate interest on a loan, and the factors on which the amount of interest charged depends.
What is Interest on a Loan?
When you borrow money from a bank, institution, or person, you repay the loan amount as well as pay an additional amount.
The borrowed sum is called the principal amount, and the additional sum paid through the course of the repayment tenure is called the interest.
Interest is the price charged for borrowing money. When a lender loans you money, they run the risk of non-repayment. They could have also used the money for themselves through the entire tenure.
To make up for these risks, lenders charge a certain interest on the principal amount, which is paid alongside repaying part of the principal sum in each sitting of repayment. Loaning money is thus also a means of investment through which banks make their money.
With each repayment you make, a portion of the money goes to the principal amount and another to the interest costs. The interest charged by the lender depends on the loan amount, rate of interest, repayment schedule, repayment tenure, income, and other loan terms.
How to Calculate Total Interest Amount for a loan scheme?
If you want to calculate the total amount of interest you have to pay on a certain principal amount, there are two possible calculations.
Simple Interest Calculation:
Some short-term loans charge simple interest. Simple interest is incurred when the interest is calculated on the principal amount alone. The total interest is less in this case, and therefore this is applicable only on some short-term loans where the lender can be assured of quick repayment.
Simple interest is the product of the principal amount, the interest rate, and the tenure for which the loan is taken.
Simple Interest = Principal * Rate of Interest * Time (number of years in term)
If you borrow an amount of INR 50,000 for 5 years at an annual interest rate of 5.5%, the total simple interest incurred on the amount will be:
Simple Interest = 50,000 * 0.055 * 5 = INR 13,750
On an amount of INR 50,000, you have to pay an interest of INR 13,750 at a 5% interest rate. Thus, at the end of 5 years, you’ll have paid a total amount of 50,000+13,750, i.e., INR 63,750, to the lender.
Compound Interest Calculation:
With most loans, the kind of interest levied is compound interest. It’s calculated not only on the principal amount but also on the accumulated interests of the previous months.
Compound Interest = Principal * [(1+r/n)^nt], where r = interest rate, n = number of compounding periods, t = overall tenure.
Loan Interest Calculation on Amortized Loans
Calculating the interest amount on loans as incurred every month is more complex. Most loans are amortized loans, which means they are repaid through monthly installments over a period of time.
These monthly repayments are termed Equated Monthly Installments (EMIs), paid every month for a certain number of years. The total number of years for which the EMI is paid is the repayment tenure.
Most loans such as student personal loans, student loans, auto loans, and home equity loans are amortized loans. Amortized loans can either be fully amortized loans or partially amortized loans.
Fully amortized loans are repaid entirely through regular periodic installments under the completion of total payment. Partially amortized loans are also paid through installments alongside a balloon payment made either at the beginning or end of the loan.
On amortized loans,
- The first few payments are interest-heavy. Out of the total EMI amount, the majority is generated to pay off the interest, while less goes towards the principal amount.
- As the remaining balance on the loan decreases, the reverse happens—the amount towards the principal loan pay-off increases, and the interest decreases.
How to Calculate Interest on Amortized Loan?
The formula for amortizing interest is as follows:
Interest paid that month= (Interest rate/ number of payments that year) * remaining balance.
Suppose you’ve taken a loan of INR 5,000 at a 6% interest rate for one year,
The interest payable on the first month would be (0.06/12)*5000, i.e., INR 25
If, for example, the EMI value is decided at INR 430
The interest on the first money= INR 25
The amount towards principal payment= INR 405
In the next month, the remaining balance will become INR 5,000-405, i.e., INR 4595.
Therefore, the interest payable on the second month would be (0.06/12)*4595, i.e., INR 22.975
The amount towards principal payment would then be INR 407.025
Notice how with each progressive month, the interest portion of the EMI is decreasing, and the principal amount portion of the EMI is increasing. This will continue for the next months until the entire principal loan amount has been paid off. The only variable figure is the amount of remaining balance, which will decrease with each subsequent month.
What are the Factors that Determine the Interest Amount?
The total interest you pay in addition to the principal loan amount depends on a number of factors. Let us look at how each of these factors influences the interest levied on the loan amount. This way, you can opt for a loan plan with a minimal interest charge.
- Loan Amount:
Larger the loan amount, the greater the interest charged. The more the amount, the more would be the return the lender would seek on the loaned amount. Thus, borrowing more money than necessary can cause further financial strains.
- Interest Rate:
One of the main factors that hugely influences the interest amount is the interest rate. A lender will charge a higher interest rate if they have doubts about the borrower’s creditworthiness. Improve your credit score by timely repayments to obtain a lesser interest rate on loans.
- Loan Tenure:
Although a longer tenure will mean smaller sums on monthly repayments, you will end up paying a larger overall sum in the long run as more interest will be accrued. Fix a tenure within which you can comfortably repay the money, but do not stretch the tenure unnecessarily.
- Repayment Schedule:
How often you repay money also impacts the interest payable. Most loans are paid off on a monthly basis, but weekly or biweekly payments are also possible. More frequent repayments minimize the interest. Be sure to iron out any such possibilities with your lender beforehand.
Most banks and NBFCs have online loan EMI calculators that help you calculate the EMI amount beforehand upon entering details about the loan plan. Once you have figured out the EMI, details about other factors, especially the interest rate and interest amount, can help you select a lender and loan plan best suited to your situation.