Silly it may sound on the face, the question has many integral complexity. A little error in understanding how interest cost works can add up to unnecessary expenses in the budget! These expenses can be irreplaceable once agreed with the lenders. Hence we have decided to throw some light on the aspect for borrowers who are planning to receive a new loan or want to switch to another loan product or lender.
The answer to this question is more generic because the interest amount depends on the type of the loan scheme entered into. For example, the interest only mortgage calculates interest differently than routine mortgages. Follow these common steps to understand the interest calculation approximately:
Before anything, open a Microsoft Excel sheet and do following calculation for easy results:
- The basic details of the loan are very important which includes the total principal amount, interest rate (APR/EPR) and the period of the loan.
- Divide the rate of interest (say 8%) by number of installments (if monthly installments then total 12) i.e. 0.08/12= 0.006. It means @0.6% interest rate.
- Now simply do multiplication of principal loan (say $25000) amount with 0.6% interest rate just derived. The result should be $167 interest amountrequired to be paid periodically (in this case it would be monthly as we divided annual interest rate by 12).
- One the above amount is derived, the person can use this formula EMI = i*P / [1- (1+i)^-n] to find out monthly installment required to be paid i.e. principal plus interest.
OR
Use PMT formula of MS Excel i.e. “=PMT(interest rate, total number of payments, present value (pv), [future value (fv) i.e.-25000 in our case,0). The zero is a control check in the formula.
- (a) Now to find out the total interest payable throughout the loan period, first multiply result received at point number 4 by number of total installments i.e. 60 in our example.
(b) The interest amount in total will be result derived at 5(a) above minus the principal amount i.e. $25,000.
This is to note that there might be nominal difference in the interest payment calculated as per MS Excel and those reported in your monthly repayment statement because the MS Excel formulas take fractions somewhat differently than other loan software.
It is advisable that the person carried his all loan details mentioned above along with him to avoid working again and again to derive the interest payment in MS Excel.
If one has understood the above calculation clearly then he can note that the principal amount portion is always higher in total monthly installment because by the lenders attribute the total payment made by borrower towards principal amount first to reduce the overall interest costs of the borrower. This is a widely accepted loan customs in finance.
Do you want to try here for calculating the interest payment of loan on your own? Try!
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