How to calculate interest on a loan

What is loan interest?

When you borrow money, you pay it back in monthly instalments — plus interest. Interest is charged as a percentage of what you owe, and the rate is set by your lender.

The amount you borrow is called the principal. The interest rate tells you what percentage of that you'll be charged each year. Together, those two things — plus the loan term — determine how much you pay in total.

A quick way to estimate interest

The simplest method is the flat interest formula:

Interest = Principal × Rate × Time

 

Term	What it means
Principal	The amount you borrow
Rate	The annual interest rate as a decimal, e.g. 10% = 0.10
Time	The length of the loan in years

 

Example

You borrow £5,000 at 10% interest over 3 years.

£5,000 × 0.10 × 3 = £1,500 in interest

Total repayable: £6,500.

This is a rough guide only. It assumes you owe the full £5,000 for all three years — which isn't how most loans actually work.

How most loans really work

Most loans are amortising. Amortising means that each monthly payment covers two things: some interest, and a chunk of what you originally borrowed. As your balance drops each month, so does the interest you're charged.

In practice, this means you pay less interest than the flat formula suggests. Using the same example, an amortising loan at 10% over 3 years would cost around £808 in interest — not £1,500.

Here's how the first three months break down:

Month	Balance owed	Monthly payment	Amount towards interest	Amount towards balance (principal)
1	£5,000.00	£161.34	£41.67	£119.67
2	£4,880.33	£161.34	£40.67	£120.67
3	£4,759.66	£161.34	£39.66	£121.68

 

Note that the monthly payment stays the same throughout the loan — what changes is how it's split between interest and the loan balance (the principal).

The interest is highest in month one and falls slowly from there. By the final payment, almost all of it goes towards clearing what you owe.

You don't need to work any of this out yourself. Most lenders show you the exact monthly payment and the total you'll repay before you agree to anything.

Difference between fixed and variable interest rates

When you take out a loan, your interest rate will be either fixed or variable.

• Fixed rate — The rate stays the same for the full loan term. Your monthly payment won't change, which makes budgeting straightforward.
• Variable rate — The rate can rise or fall during the loan term, often in line with the Bank of England base rate. If it drops, you pay less. If it rises, you pay more.

Most loans carry a fixed rate. Variable rates are more common on products like credit cards and some mortgages.

If you're on a variable rate loan, it's worth keeping an eye on the Bank of England base rate — any change there could affect what you owe each month.

What is APR?

When you look at loan offers, you'll see a figure called APR — Annual Percentage Rate. This is the interest rate plus any fees, combined into a single yearly figure.

It's more useful than the headline rate alone, because two loans can have the same interest rate but different fees. The APR accounts for both, so you're comparing like for like. UK lenders are required by law to display it.

What affects how much interest you pay?

Your interest rate matters, but it's not the only thing that affects what you pay. All three of these factors can make a significant difference to the overall cost.

• Loan term — A longer term means lower monthly payments, but you pay more interest overall
• Loan amount — The more you borrow, the more interest builds up
• Interest rate — Even a small difference in rate can add up over a long term

Look at the total you'll repay, not just the monthly payment

It's easy to focus on the monthly payment, but the total amount you'll repay tells the full story. Before you apply, check two figures: the APR and the total amount repayable over the full term. A loan calculator makes this easy — plug in a few numbers and you can compare deals side by side without any maths.