Being in debt sucks. There’s nothing worse than paying all those interest charges each month when you could be spending your money on something else! Today I’m going to show you how interest is calculated to help you understand how much your debt is costing you each month.
Would you prefer to watch instead of read? You’re in luck! This video contains all of the information in this article.
Before I go any further, I do want to let you know that this post will involve a little bit of math, but it’s okay! Don’t be scared. I’m going to walk you through it step by step, and you can even do the calculations right on your phone.
As I’ve worked toward paying off my debt, one of the biggest motivating factors has been that with every payment, I’d be reducing the principal and paying less and less each month in interest charges – those fees that the lender is charging me to borrow their money. Interest makes me feel like I’m being charged a fee every month, just for being in debt. Give me a thumbs up if you know what I’m talking about. If you’ve been paying the minimum monthly payments on your debt, you can easily see just how much you’re paying in interest by taking a look at your monthly statements. But how does your lender arrive at that number?
Calculating Simple Interest
The calculation your lender is doing is actually quite simple. All you’ll need is the interest rate on the loan (or credit card) you’re looking at, and the total amount you owe. Let’s say I’ve got a personal loan with an interest rate of seven percent and the total amount I owe on that loan is thirteen thousand dollars.
Step 1
Start with your interest rate and divide that by one hundred, to turn the percentage into a decimal. In this case, I wind up with zero point zero seven.
Step 2
Now I take that number and multiply it by the total amount I owe on that loan. If I do that, I get nine hundred and ten dollars.
This number represents the amount of interest that would accrue on this loan in a year.
Step 3
If I want to see the average monthly interest amount, I simply divide by twelve since there are twelve months in a year. Doing so yields an answer of seventy five dollars and eighty three cents.
This would be roughly the amount I expect to see listed as interest charges on my statement this month. Go ahead and try this with one of your loans now. Keep in mind the interest could vary slightly from month to month, depending on the number of days that month or when exactly your payments are processed.
Car Loans
Now, it’s fairly common for people to take out loans of thirty, forty, or fifty thousand dollars on something like a new car.
If I had a fifty thousand dollar loan with the same seven percent interest rate as earlier, the interest alone would amount to thirty five hundred dollars per year, or almost three hundred dollars per month – and that’s just the interest. That interest is pure profit for banks, or in this case, car companies, who are making those loans. With that kind of upside, it’s no wonder they’re so excited to put you in a new car with zero dollars down!
Extra Payments = Interest Saved
This calculation works the other way around, too, which is one of the reasons I find myself using it so often as I make additional payments on my loans.
Let’s say you managed to set aside four hundred dollars in your budget this month to put towards that loan from earlier. You could use this calculation to figure out how much less interest you’ll pay on that loan going forward. Let me show you how that would work: Just like earlier, I start with my interest rate and divide it by one hundred. Again I wind up with zero point zero seven.
This time, I take that number and multiply it by the additional amount I’m paying – in this case four hundred dollars. I wind up with twenty eight dollars. That’s the amount of interest I would’ve paid over the next twelve months had I not made this extra payment. That’s twenty eight dollars that I can now keep for myself.
I really encourage you to try these calculations out with some of your own loans and credit cards, to truly begin to understand just how much your debt is costing you. Seeing these numbers motivates me to do all that I can to pay off my debts faster – maybe it’ll do the same for you! If you have any questions or need some help, leave me a comment below and I’ll give you a hand.