How to calculate interest on a loan

What is loan interest?

When you borrow money from a lender, they charge you a fee for using their funds. This fee is called interest. Think of it as the cost of borrowing. The amount you borrow is called the principal, and the interest is calculated as a percentage of this amount over time.

Interest calculation

A simple way to calculate interest uses this formula:

• Multiply the amount you borrowed by the interest rate
• Then multiply that by the time period (in years)

Example: If you borrow £5,000 at 5% interest for one year, you multiply £5,000 by 0.05 (which is 5% as a decimal) to get £250 in interest.

What is APR?

When you compare loans, you'll see something called APR, which stands for Annual Percentage Rate (or for secured loans and mortgages – APRC - Annual Percentage Rate of Charge). This figure is very useful because it includes both the interest rate and most fees associated with the loan, giving you the true cost of borrowing.

Example: Two loans might both have a 5% interest rate, but one charges a £200 arrangement fee while the other charges £500. The loan with the higher fee will have a higher APR, making it more expensive overall.

Always compare APRs when choosing between loans, as this gives you the clearest picture of what you'll actually pay.

Calculating your monthly payments

Working out your monthly payment involves harder maths because each payment reduces your balance, which then reduces the interest you owe. Most people use online loan calculators for this, but the formula considers the loan amount, interest rate, and loan length to spread your repayments evenly across the borrowing period.

Example: For a £5,000 loan at 8% APR over three years, you'd pay roughly £156 per month. Over those 36 months, you'd repay the £5,000 you borrowed plus about £632 in interest, making the total repayment around £5,632.

This is why it’s important to check that the monthly payment fits comfortably within your budget.

Fixed vs variable interest rates

Fixed interest rates stay the same throughout your loan term, so your monthly payments never change. This makes budgeting easier because you know exactly what you'll pay each month.

Variable interest rates can go up or down based on market conditions. While they might start lower than fixed rates, they carry more risk because your payments could increase if interest rates rise across the economy. Equally, they could fall, which would mean your payments may too.

Tips for managing loan interest

• The faster you repay your loan, the less interest you'll pay overall. Some loans allow you to make extra payments or pay off the loan early. There could be early repayment charges, so you should check with your lender first.
  
  
• Choosing a shorter loan term means you'll pay less interest overall because you're borrowing the money for less time, even though your monthly payments will be higher. For example, a £10,000 loan at 7% APR costs £1,088 in interest over three years, but £1,880 over five years – a difference of £792.
  
  
• Your credit score can significantly affect the interest rate you're offered. People with excellent credit scores typically receive the lowest rates, while those with poor credit pay more. Improving your credit score before applying for a loan can save you hundreds of pounds in interest.
  
  
• Remember to only borrow what you can afford to repay, and where possible, consider any future changes in circumstances.

Getting help

If you find loan calculations confusing, don't worry. Loan calculators are available online and take seconds to use. Simply enter the amount you want to borrow, the loan term, and the interest rate to see what your monthly payments would be and how much interest you'd pay in total.

You can also speak with a loan broker who can guide you through the process and suggest the best possible solution for your circumstances.

Understanding how loan interest works puts you in control of your borrowing decisions. You can compare offers more effectively, choose the right loan for your circumstances, and avoid paying more than necessary.