A Complete Guide to Calculating Loan Interest
Learn to calculate simple and compound interest correctly. Avoid the common mistakes that eat into your margin.
Calculating interest correctly is the foundation of a profitable lending business. A small error in the formula can cost you money or lose you customers through unfair charges.
The basics
Principal (P)
The original amount of money lent.
Interest rate (i)
The percentage charged for the use of the money (e.g. 10% per month).
Term (n)
The time over which the money is lent (months, days, years).
Interest (I)
The earnings generated by the loan.
1. Simple interest
This is the most common method in informal personal lending. The interest is always calculated on the original principal.
Example: you lend $1,000 at 10% a month for 5 months.
I = 1,000 × 0.10 × 5 = $500 of total interest.
Total to repay = $1,500.
2. Compound interest
Here the interest generated is added to the principal and generates further interest. It is common in bank loans and credit cards.
It is “interest on interest”. Over the long run it produces far more for the lender, but it costs the customer more.
3. Interest on the outstanding balance
Interest is calculated only on what the customer owes right now, not on the original loan. As they repay principal, the interest falls.
This is the fairest method and the one formal financial institutions prefer. It gives the customer a reason to pay faster.