How to Calculate Interest
Whether you're looking to take out a loan or shopping around for the best high-yield savings account, the interest rate is usually the single most important factor to consider.
But what exactly goes into determining an interest rate and how can you work out the actual amount? Here, we'll break down the details of how to calculate interest so you have a better understanding of how it all works.
Table of Contents
What is Interest?
When you’re borrowing money from a lender, you pay interest in exchange for the loan. The interest rate depends on the current overall market rates, your credit score, income, loan term, the type of loan, and the total loan amount.
If you open a savings account at a bank, the bank uses the money that you deposit to lend to other consumers. In exchange, the bank pays you interest at a rate usually between 0.01% and 1%.
Some online banks dole out interest on chequing accounts as well as savings accounts.
How Often is Interest Calculated?
Interest may be calculated on a daily, monthly, quarterly, or annual basis, depending on the type of loan or savings product. In some cases, interest may be measured daily but only deposited once a month.
How Does Interest Work?
When taking out a loan, you’ll often see two terms: interest rate and Annual Percentage Rate (APR). Some lenders will use the terms interchangeably even though they mean different things.
APR includes both the interest assessed on the loan and any initial fees assessed by the lender. This can include origination fees, discount points, and appraisal fees.
APR is most commonly used when you’re taking out a mortgage, auto loan, or credit card. Some loans like student loans don’t charge extra fees. In this case, the lender will only refer to the interest rate and not the APR.
Different Types of Interest
Interest comes in many forms. We'll take a look at some of those types of interest below, such as compound, simple, fixed, and variable interest.
Compound interest, mostly seen with savings accounts and investments, is the term for interest that accrues on top of interest.
Let’s try an example of how to calculate compound interest. Let’s say you stash $20,000 in a savings account with 2% interest. In a year, you earn $404.02 in interest, making the new total $20,404.02. In the second year, you earn $412.17 in interest, $8.15 more than the previous year because the interest was calculated from the new total.
Your account will grow faster every subsequent year because you earn interest on a greater amount. While this effect is modest in the savings account example used above, it’s much more dramatic when applied to an investing account.
Simple interest refers to interest that accrues only on the original principal balance, not on the interest too. Short-term personal loans and auto loans often use simple interest, as well as some mortgages.
Most loans have fixed interest rates which means the interest rate stays the same for the entire lifetime of the loan. The only way that a fixed interest rate can change is if you refinance the loan for a new interest rate.
As the name suggests, variable rate loans have an interest rate that can change during the loan term. Variable-rate loans come with a range within which the rate can fall anywhere. For example, if the variable rate range is between 10% and 15%, your interest rate may be as low as 10% or as high as 15%.
The initial rate on a variable rate loan is often lower than a fixed-rate loan, but borrowers have to be prepared for it to increase suddenly. Some variable-rate loans change as often as every month.
Variable interest rates are most common with personal loans, private student loans, and credit cards. Some mortgages have variable rate loans, aka adjustable-rate mortgages (ARMs).
How to Calculate Interest Rates
Calculating interest is fundamental in financial planning. Below, we'll delve into how interest rates are calculated for banking tools, loans, and credit cards.
When you have an interest-bearing chequing or savings account, the bank will calculate interest based on the daily balance and deposit the accrued interest once a month.
Interest rates on both chequing and savings accounts can vary depending on the overall market rate. They usually change a few times a year.
If you buy a certificate of deposit (CD) from a bank, the interest rate will stay locked in for the term. The bank will deposit the interest once the term is over (the CD’s maturity date).
When you take out a loan, the lender will charge interest on the principal balance. As you continue to make payments, both the principal and the interest charges each month will decrease.
Here’s how it works. Let’s say you take out a $30,000 loan with a five-year term and a 10% interest rate. Your monthly payment is $637.
To calculate how much interest you’ll pay on the first payment, divide the 10% interest rate by 12 months to find the monthly interest rate. In this case, the rate is 0.0083. Multiply that by the $30,000 loan balance which comes out to $250.
Out of the first $637 monthly payment, $250 will go toward interest and $387 will go toward the principal. But for your second payment, the interest will only be $245.79 because the principal balance will have decreased.
You only have to pay credit card interest if you don’t pay off the entire statement balance in full by the due date.
If you have an outstanding credit card balance, you’ll be charged interest on that credit card debt until you pay it off.
To figure out how to calculate credit card interest, go to your most recent credit card statement and locate the APR.
Divide the APR by 365 to find the daily interest rate. Multiply that by the average daily balance which you’ll have to calculate manually.
Our Final Thoughts
Knowing how interest works can help you work out whether you’re getting a good deal at the bank or with a lender. The more interest you can save on a loan, the more you can use it for other expenses and savings goals.
Frequently Asked Questions
In the US, the Federal Reserve is responsible for setting interest rates. They each meet eight times a year to determine whether short-term interest rates should be decreased or increased. Banks and lenders respond by either lowering their rates or dropping them.
The Federal Reserve will typically raise interest rates when the economy and stock market are strong and decrease rates when the economy needs a boost.
During the COVID-19 pandemic, the Fed is keeping interest rates low to propel the economy. This has also led to a surge in home purchases as consumers take advantage of low-interest rates on mortgages.
If the market rebounds and unemployment drops, the Fed may decide to increase interest rates.
Whether or not an interest rate is seen as good depends on the current market rate. A few years ago, a 5% rate on a mortgage was a good deal. Now, it would be considered higher than the best interest rates available.Each type of credit product has its own range of interest rates. Most credit cards have APRs between 15% and 18%, so a 10% APR would be considered good. At the same time, a 10% rate on an auto loan would be a high rate.