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How Loan Interest Works
Interest is the price of borrowing money. You borrow a principal, and you pay it back with interest on top. How that interest is figured decides how much a loan really costs — and it is simpler than lenders make it sound.
Simple interest
Simple interest is charged only on the original principal. The formula is I = P × r × t: principal times annual rate times years. Borrow $10,000 at 5% (an example rate) for 3 years and the interest is $10,000 × 0.05 × 3 = $1,500.00, for a total of $11,500.00. Simple interest is common for some short-term loans, but most US home, car and personal loans do not use it.
Compound interest
Compound interest is charged on the principal plus the interest already added. The formula is A = P(1 + r/n)nt, where n is how many times a year interest compounds. The same $10,000 at 5% for 3 years grows to $11,576.25 compounded once a year, $11,614.72 compounded monthly, and $11,618.22 compounded daily. Compounding more often adds a little more, because interest starts earning interest sooner — but the rate and the time matter far more than the frequency. Try it on the Interest Calculator.
How a monthly loan payment is split
Most US loans amortize: you pay the same amount every month, and each payment is split between interest and principal. Interest for the month is the balance times the monthly rate (annual rate divided by 12). The rest of the payment cuts the balance. Take a $20,000 loan at 7.5% (an example rate) over 60 months: the monthly payment is $400.76. In month 1, interest is $125.00, principal is $275.76 and the balance falls to $19,724.24. In month 60, interest is $2.49, principal is $398.27 and the balance reaches $0.00. Total interest is $4,045.54. The full table is on the Amortization Calculator.
APR vs interest rate
The interest rate is what the lender charges on the balance. APR — annual percentage rate — is the interest rate plus most fees, spread over the year, so it is usually a little higher. Two loans can have the same interest rate and different APRs if one charges bigger fees. When you compare loans, compare both: the interest rate sets your monthly payment, and the APR shows the fuller cost. The calculators on this site use the interest rate you enter, not the APR, because the monthly payment is figured from the rate.
What makes interest higher or lower
Three things matter most: the rate, the amount borrowed and the time. A higher rate or a bigger loan means more interest. A longer term means a smaller monthly payment but more interest overall — on the $20,000 example, 36 months costs $2,396.48 in interest and 60 months costs $4,045.54 at the same 7.5% rate. Paying extra, even $25 a month, cuts the balance faster and saves interest: on that loan, $25 extra a month saves $294.83 and finishes the loan 4 months sooner. See the Loan Payoff Calculator.
Sources and method. Standard loan amortization formula: monthly rate = annual rate / 12; monthly payment = P × r(1+r)n / ((1+r)n − 1). Simple interest I = P × r × t; compound interest A = P(1 + r/n)nt. Rates in the examples on this page are examples only, not live market rates. Results are estimates, not financial advice.
Estimate, not financial advice. This calculator uses the numbers you enter and the standard amortization formula. Your lender’s figures, fees and payoff rules can differ. Check the loan agreement and talk to a financial professional before you borrow.