Before you take out a bank loan, you need to know how your interest rate is calculated and how to calculate it yourself.
Banks use many methods to calculate interest rates, and each method changes the amount of interest you pay. If you know how to calculate interest rates, you will better understand your loan agreement with your bank. You will also be in a better position to negotiate your interest rate with your bank.
When a bank quotes an interest rate, it quotes what is known as the effective interest rate, also known as the annual percentage rate of charge (APR). The APR or the effective interest rate is different from the interest rate shown because of the effects of the interest mix.
Banks can also link your interest rate to a benchmark, usually the prime rate. If your loan includes such a provision, your interest rate will vary depending on the fluctuations of this index.
How to calculate interest on a one-year loan
If you borrow $ 1,000 from a bank for one year and you have to pay $ 60 in interest for that year, your interest rate is 6%. Here is the calculation:
Effective rate on a simple interest loan = interest / principal = € 60 / € 1000 = 6%
Meanwhile, this loan becomes less advantageous if you keep the money for a shorter period. For example, if you borrow $ 1,000 from a bank for 120 days and the interest rate stays at 6%, the effective annual interest rate is much higher.
Effective rate = Interest / Principal X days of the year (360) / Number of days of loan default
Effective rate of a loan of less than one year = 60 € / 1000 € X 360/120 = 18%
The effective interest rate is 18% because the funds are only used for 120 days instead of 360 days.
Effective interest rate on a discounted loan
Some banks offer discounted loans. Discounted loans are loans where the payment of interest is subtracted from the principal before the loan is disbursed.
Effective rate of a reduced rate loan = interest / principal – interest X days in the year (360) / number of days the loan is in progress
Effective rate of a reduced rate loan = € 60 / € 1,000 – € 60 X 360/360 = 6.38%
As you can see, the effective interest rate is higher on a soft loan than on a simple interest loan.
Effective interest rate with clearing balances
Some banks require small businesses that apply for a loan from a merchant bank to keep a balance, known as a clearing balance, with their bank before approving a loan. This requirement increases the effective interest rate.
Effective rate with offsetting balances (c) = interest / (1-c)
Effective rate offsetting = 6% / (1 – 0.2) = 7.5% (if it is a 20% off balance)
Effective interest rate on installment loans
Many consumers have installment loans, which are loans repaid in a number of payments. Most auto loans are installment loans, for example.
Unfortunately, one of the most confusing interest rates you will hear on a bank loan is an installment loan. Interest rates for installment loans are usually the highest interest rates you will encounter. Using the example above:
Effective loan installment rate = 2 X Annual number of payments X Interest / (Total number of payments + 1) X Main
Effective rate / installment loan = 2 X 12 X 60 € / 13 X 1,000 € = 11,08%
The interest rate on this installment loan is 11.08%, compared to 7.5% on the loan with offsetting balances.