The correct calculation of interest matters to your bottom line, whether you're borrowing or lending money. If you're borrowing money, you need to make sure you're not being overcharged by the bank and that you budget for the amount of principal and interest you will pay each month. If you're lending money, you need to know how much money your borrowers should be paying you. Even though interest rates often are expressed per annum, or per year, interest typically is paid or calculated on a monthly basis. If you don't know the right formulas to use to calculate the interest, you'll come up with the wrong amounts.
Simple Interest Formula
Simple interest ignores the impact of interest compounding, so you can use it when interest compounds once per year or the interest is paid off each month. To calculate simple interest on your loan each month, divide your annual interest rate by 12 to find the monthly interest rate. Then, multiply the monthly interest rate by the balance on your loan to calculate the monthly interest. You could use the simple interest formula to calculate monthly interest if you have an interest-only loan. Because you pay only the interest, the principal won't go down each month and your monthly payment will remain the same until you make additional principal payments.
For example, say you have an annual interest rate of 9 percent on an interest-only loan with a balance of $20,000. Divide 9 percent by 12 to find the monthly interest rate is 0.75 percent. Then, multiply 0.75 percent by $20,000 to find the monthly interest due is $150. That monthly interest rate won't change until you make an additional principal payment because the $150 you pay each month only pays the accrued interest and the principal remains at $20,000.
Compound Interest Formula
If interest compounds more frequently than annually, the formula for calculating the monthly interest rate gets much more complicated. First, divide the interest rate by 100 to convert it to a decimal. Then, add 1 to the result. Next, raise the number to the 1/12th power with a calculator. On the calculator, push the exponent button, often a "^" or "x^y" and then enter "(1/12)". Then, subtract 1. Finally, multiply by 100 to convert the rate to a percentage.
For example, say you have a loan that is accruing interest at 12.6825 percent per year that compounds interest monthly. Divide 12.6825 by 100 to get 0.126825. Then, add 1 to get 1.126825. Next, raise 1.126825 to the 1/12th power by entering "1.126825^(1/12)" to get 1.01. Then, subtract 1 to get 0.01. Finally, multiply 0.01 by 100 to find the monthly rate is 1 percent. So, if there was a balance of $10,000 on the loan, $100 of interest accrues each month.