No matter what kind of loan, or what the rate is, interest adds to the overall cost of your loan. The interest rate you pay and whether your lender uses the declining balance or add on method to calculate total interest determines how much you will need to repay each month. While federal regulations require your lender to disclose both the terms of your loan and the total interest you will pay over its term, knowing how to calculate total interest yourself can help you better understand the process.
Calculate total interest using the declining balance calculation method. Using this method, you only pay interest on the outstanding balance, so the closer you get to paying the loan in full, the less the interest charge will be. Assume you are borrowing $500 at an interest rate of six percent for a period of six months and your monthly principal payment is $83.33 each month.
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Multiply the full amount of the loan by the interest rate to calculate interest for the first installment payment. For example, multiply 500 x .06 for a first month interest payment of $30 and a monthly payment of $113.33.
Subtract the first month principal payment from the loan amount to set the amount on which you will calculate interest for the next installment. For example, $500 – 83.33 shows that next month you will calculate interest using a balance of $416.67 and your second interest payment will be $416.67 x .06, or $25, and a monthly payment of $108.33.
Calculate interest for the remaining installment payments, basing each calculation on the new balance of the loan. Using the same example, you will pay interest totaling $20 in the third month, $15 in the fourth month, $10 in the fifth month and $5 in the sixth and final month.
Add the monthly interest payments to arrive at $105, or the total amount of interest you pay on the loan.
Compare the amount of interest you ultimately pay by calculating total interest using an add-on calculation method. Multiply the total amount you borrow by the interest rate of the loan by the number of payments you will make. If you borrow $500 at an interest rate of six percent for a period of six months, the calculation displays as 500 x .06 x 6 to arrive at a total interest calculation of $180.00. Using this method, your monthly payment will remain a constant $113.33 over the six month term of the loan.
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