Knowing how to calculate principal and interest is a valuable skill for anyone who has a loan or is planning to take one. When you know how to calculate monthly principal and interest, you’ll find it easier to manage your finances. You’ll have a better understanding of how much it will cost you to borrow money at different loan terms. Ultimately, it will help you make smart borrowing decisions.
Before diving into how to calculate principal and interest, it helps to understand the different terms involved.
Principal refers to the amount that you borrow from the lender. This does not include the interest or any additional fees that the lender adds on.
For example, let’s say you need to borrow $2,000 to cover some expenses. The $2,000 is the principal that you’re borrowing from the lender. But no lender will lend you any money for free. They will charge you a fee for borrowing. However, regardless of the fees and interest, your actual principal amount is $2,000.
Interest is the price the lender charges you for borrowing money. When you take a loan, you have to pay back the principal amount that you borrowed plus interest. This has to be done in monthly payments. So every month you will have to pay back a portion of the principal plus interest. The payment schedule is calculated using an amortization formula.
Lenders use amortization as a way to keep payments consistent. Here’s how amortization works.
When you just start with the repayments, the larger percentage of your monthly payments go toward paying the interest. Only a small percentage of the payment goes toward reducing the principal amount. As you get nearer to the end of the loan term, this trend reverses. A larger percentage of your monthly payments go toward lowering the outstanding balance. And only a small percentage of the payments go toward paying the interest. However, despite this difference, the payments remain the same throughout.
The amortization formula breaks down the total principal and interest amount into equal monthly payments. This is spread over the term of the loan. If your loan term is 20 years, the monthly payments are calculated in a way that the full principal and interest will be paid off at the end of 20 years. This allows you to make fixed payments every month on your loan even as your outstanding balances keep reducing every month.
When researching loan interest rates, you will likely come across two terms – interest rate and APR. APR is the abbreviation for annual percentage rate. Interest rates and APR are two completely different things. Before you sign a loan contract with a lender, it’s important to understand the difference between the two.
Interest rate has a straightforward meaning. It is the rate of interest the lender is charging you for borrowing money. It is calculated as a percentage of the total loan amount.
APR refers to the total annual cost of borrowing money. This factors in the interest rate, loan origination fees, and any other administration fees that the lender may charge.
When taking a loan, it’s important to check both, the interest rate as well as the APR. Some lenders charge very low-interest rates to entice prospective borrowers. They then add on high origination and miscellaneous fees that can increase the cost of borrowing significantly. Depending on the add-on fees, you could end up paying more in interest even if the lender is offering you the lowest rate. Lenders are legally required to disclose the APR when they provide you with a loan estimate so you can get an accurate picture of your total cost of borrowing. However, many hide this information in the fine print.
Always make sure to check the fine print before signing an agreement with any lender. If in doubt, ask the lender about how they’ve calculated the principal and interest. Last but not least, always compare multiple lenders before choosing any one. You may find it cheaper to borrow from a lender charging a slightly higher interest rate, depending on their miscellaneous fees and how they calculate principal and interest payments.
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