How to Calculate Interest Charged on the Principal of a Loan

Borrowing money isn't necessarily a bad thing. Without mortgage and automobile loans, the average person wouldn't be able to raise enough cash to buy a home or car outright. Anyone borrowing money should have a basic knowledge of financial calculations in order to understand just how the money they send each month eventually pays off their loans. One such example is for you to know how to calculate interest charged on the principal of a loan.

Instructions

1. Understand the idea of compound interest. Since most loans require monthly payments, lenders charge interest monthly, not once a year. This means that you pay one-twelfth of the annual interest rate each month. If your loan has an interest rate of 6 percent, you pay .5 percent per month on the outstanding balance, or principal.

2. Calculate the monthly payment on your loan. Using a financial calculator (available online) or Excel, input the interest rate you expect divided by 12 (for monthly payments), the total number of payments to be made and the purchase price of the house or car. For example, in Excel you would type =PMT(.06/12, 360, -100000). This would calculate the payment of a $100,000 house at 6 percent interest for 30 years (360 months). You show the $100,000 amount as a negative because it is money you owe. The monthly payment in this problem comes to $599.55.

3. Amortize your loan. The word "amortize" is a fancy term that simply means to break down how each payment applied affects the remaining loan balance. In the above case, your initial loan balance is $100,000. You make a payment of $599.55. You pay one-twelfth of 6 percent interest each month on the outstanding balance. $100,000 times .06/12 equals $500.00. The payment of $599.55 minus $500.00 interest equals $99.55 applied toward the principal. The outstanding principal amount is now $100,000 minus $99.55, or $99,900.45.

4. Repeat the above step to see how much of each consecutive payment goes toward principal and interest. Each month, the amount paid toward interest decreases and the amount applied toward principal increases until eventually you have a zero balance.

5. Multiply the total number of payments you owe by the monthly payment amount. In the above example, multiplying $599.55 times 360 equals $215,838.00. Subtract the amount you borrowed from this number to find out the total interest you paid ($215,838.00 minus $100,000 equals $115,838.00). Most people end up paying more total interest than the purchase price of their home when financing a house over 30 years.