Calculating interest for a loan

Many people do not know how to calculate interest. This is also because interest calculations are not done the same way for all loans.

Therefore, differences can arise when calculating interest and when repaying the loan. If borrowers know the type of interest calculation, they can better understand the composition of total costs and installments.

When calculating interest, lending institutions are not fundamentally bound to any specific method. However, banks generally use the Euro interest method (ACT/360). It is more interesting to consider whether banks quote a monthly or annual interest rate.

The monthly interest rate appears very small to customers at first glance. However, when this is expressed as an annual rate, it can be very high. Consumers should therefore always calculate and compare the effective annual interest rates. Interest on a loan is always calculated on the outstanding principal.

An example illustrates the procedure when calculating interest:

A loan of 10.000,00 EUR is taken out with an interest rate of 5%. The loan installment is 300,00 EUR. Billing for loans very often takes place monthly. The interest is therefore charged to the borrower every month and offset against the installment.

In the first month the customer has to pay 41,67 EUR in interest. The outstanding balance at the end of the month is therefore 9.741,67 EUR. In the following month, only the remaining outstanding balance of 9.741,67 EUR must be charged interest. The amount of interest to be paid will therefore decrease month by month.

Mathematical calculation of interest

Interest calculation is a form of percentage calculation. The base value is given as the capital, the percentage rate as the interest rate, and the percentage value as the interest.

Calculating interest for a fixed period and a fixed amount is the simplest starting point.

For example, if €5,000 bears 6% interest per year, you calculate:

5000*6/100 = 300,

because 6% = 6/100.

Six percent of €5,000 therefore corresponds to €300.

In the financial sector, it is important when calculating interest whether it is calculated on a daily, monthly or annual basis.

In most cases, the interest rate per year (p.a.) is stated and installments are paid monthly.

Thus, each month corresponds to 1/12 of the annual interest rate. This monthly rate is then used to calculate interest on the outstanding balance each month.

Example:

A €5,000 loan is taken out at the beginning of a month. The first installment of €500 is already repaid at the end of the month.

For the first month, the following interest accrues at 5% p.a.:

5000 € * (5/100 * 1/12) = 20,83 €

After the first repayment, the outstanding balance is therefore 4500 € + 20,83 €. This €4,520.83 is then again charged interest at 1/12 of 5%. The formula then looks like this:

4520,83€ * (5/100 * 1/12) = 18,84 €

In the 11th month in this example, only the interest on the borrowed amount and the interest on the interest (compound interest) remain.

In this example, repayment would therefore take place over 11 months, with €117,97 in interest accruing. The nominal interest rate is always used to calculate the interest.

Build your own interest calculator with Excel

If you want to build your own interest calculator with Excel, you need the following columns.

• Period: Here the accounting intervals such as months, days or years are counted.
• Outstanding balance: Start with the total loan amount. Below that follow loan amount - paid installment + interest (from the 2nd row the amount must be calculated)
• Installment amount: Here the amount to be paid in the specified intervals is entered, e.g. €500 per month
• Proportional interest rate per interval, e.g. 1/12 * 5% if an annual interest rate of 5% is assumed and is charged monthly. The value is the same in all rows if the interval does not vary.
• Interest per interval, calculated from (loan amount - repaid amounts) * proportional interest rate

You therefore only calculate the outstanding balance and the interest per interval.

The outstanding balance in the 2nd month results from the formula: =B2-C2+E1

Column D results from: 5% * 1/12

Column E is calculated with this formula: = B2*D2

This calculator can be used both for calculating installment loans and for calculating interest income from investments. For investments, however, the term outstanding balance would be replaced by initial capital plus returns. In addition, instead of an installment amount there might be deposits that are added to the initial capital along with the interest. As a result, the final capital at a specified time could be calculated.

Different interest intervals

Banks often use different interest intervals when calculating interest. With a standard installment loan interest is generally calculated monthly. For long-term construction financing, however, interest may also be charged quarterly.

The outstanding balance is reduced by the principal repayment in the first two months. Only in the third month are the interest charges applied.

In normal cases the interest charge exceeds the principal repayment, so the outstanding balance increases. Public promotional loans are also interest-bearing on a quarterly basis. Customers should definitely check the interest intervals when taking out long-term construction financing.

Calculate interest: create interest and amortization schedules

Borrowers can usually access the capital balance of their outstanding loans via the Internet. However, many customers find it difficult to calculate the interest for the coming months or years themselves.

Customers who would like to find out the interest balance for the coming months and years can request a interest and amortization schedule to be printed. Interest and amortization schedules can usually be requested free of charge from the financing bank.

In the interest and amortization schedule, the interest, principal repayments and outstanding balances for a desired term can be viewed. Borrowers can also print the interest charges for the entire fixed-rate period.

However, it should be noted that the interest and amortization schedule changes as soon as a prepayment is made. With the interest and amortization schedule, borrowers can also view the total interest costs of the loan.

Calculating variable interest

When calculating interest, an interest rate that is fixed by the loan is always used. However, some borrowers prefer variable interest. With variable interest, the interest rates can change monthly, so the interest balance to be paid can also change.

If interest rates rise, interest payments can increase even though the loan balance has decreased. Borrowers should therefore keep an eye on the interest rate level and, if necessary, have the interest fixed.

A variable rate is worthwhile if interest rates are expected to fall. If interest rates are expected to rise, fixed-rate agreements should be made. Interest calculation is then carried out at the fixed interest rate.

For this reason, it is important to take out construction financing when interest rates are low. If interest rates rise after the construction financing has been concluded, interest calculation is always based on the low fixed rate.