When you borrow money by taking out a mortgage, car loan or student loan, the transaction comes with a promissory note. A promissory note is an agreement that spells out the loan's terms and conditions, including the interest rate. Interest is calculated based on the interest rate and the balance of the loan in accordance with the terms of the promissory note.
Principal and Interest
Promissory notes usually call for monthly payments. Interest is calculated each month based on the outstanding balance of the loan, called the principal. Suppose you take out a loan for $1,000 and the promissory note stipulates a 12 percent annual interest rate and a monthly payment of $50. One month's interest is one-twelfth of the annual rate or 1 percent of the principal. For your first payment, the interest comes to $10. The other $40 is applied to the principal and reduces it to $960. Next month the same calculation will be repeated using the new principal of $960.
Factors Affecting Interest Calculation
Lenders use various methods to calculate interest for promissory notes. The basic computation is similar for any loan, but a lender may choose to calculate interest using the balance at the end of the month or the average daily balance. Another option is adding fees either before or after calculating interest. Lenders also may calculate interest daily, monthly or at some other time interval. Each of these variations affects the amount interest you pay.