How to calculate principal and interest

The loan amount you borrow is called the principal amount, and interest is the cost of borrowing charged by the lender. To calculate principal and interest, multiply the principal amount by the interest rate and multiply the result by the number of years of the loan. Calculating your principal and interest will tell you how much a simple interest loan will cost you.

However, calculating principal and interest becomes more complex if the loan uses another interest calculation, such as an amortized loan (mortgage) or compound interest (credit card). With simple interest, your interest payments remain fixed, while with amortized loans, you are charged more interest in the early stages of the loan. Find out what interest rates lenders can charge you and how to calculate principal and interest using a mortgage example.

Principal and interest

When you make a loan payment, part of it goes toward paying off interest and part of it goes toward paying off the principal. Understanding how banks and credit unions calculate these components can help you understand how you’ll repay your loan.

Main

The principal amount is the original loan amount, not including interest. For example, with a mortgage, let’s say you buy a house for $350,000 and put down $50,000 in cash. This means you are borrowing a principal amount of $300,000 from your mortgage lender, which you will need to repay over the life of the loan.

Interest

Interest is the amount the bank charges for lending you money. Typically, short-term fixed-rate loans, such as personal loans, use simple interest calculations. Long-term loans, such as mortgages and some auto loans, are amortized.

Example of calculating mortgage interest

Let’s say the loan in the example above is a 30-year mortgage with an amortizing interest rate of 4% per annum. Because you make monthly payments, the 4% interest rate is divided by 12 and multiplied by the outstanding principal amount of your loan. In this example, your first monthly payment would include interest of $1,000 ($300,000 x 0.04 APR ÷ 12 months).

If you enter the purchase price, down payment, interest rate and loan term into Investopedia’s mortgage calculator, you’ll see that your monthly payments to the lender will be $1,432.25. As noted earlier, $1,000 of your down payment strictly covers interest costs, meaning the remaining $432.25 goes toward paying off the outstanding loan balance or principal.

The example above does not include other expenses such as mortgage insurance and taxes on property held in escrow.

How does depreciation work?

If you have a fixed-rate loan, your monthly mortgage payment will remain the same. In theory, the interest rate is multiplied by the reduction in the principal balance. The reason the amount you pay doesn’t decrease is because lenders use amortization when calculating your payment, which helps keep your monthly bill consistent.

Depreciation example

If we stick with our previous example and assume you don’t refinance, your loan payment will be the same 15 years later. But your principal balance will be reduced. After 15 years, your loan balance will be approximately $193,000.

Multiplying $193,000 by the interest rate (0.04 ÷ 12 months), the interest portion of the payment is now only $645.43. However, you are paying off most of the principal, which means that $786.82 of the $1,432.25 monthly payment goes toward principal payment.

The table below shows the monthly payments at various stages of a 30-year mortgage. You will notice that the interest portion of your monthly payment decreases and the principal portion increases over the life of the loan. You can use an amortization calculator to help you determine the interest and principal amount of your loan.

Mortgage amortization by principal and interest
Year	Main	Interest	Monthly payment
Year one	$432.25	1000 US dollars	$1432.25
15 years	$786.82	$645.43	$1432.25
20 years	$960.70	$471.54	$1432.25
30 years old	US$1427.49	$4.76	$1432.25

During the final year of your mortgage, you pay off mostly principal and very little interest. By smoothing out your payments this way, mortgage lenders make your payments more manageable. If you were to pay the same principal amount over the life of the loan, you would have to make much higher monthly payments immediately after taking out the loan, and those amounts would drop sharply at the end of the repayment.

If you’re wondering how much you’ll pay in principal versus interest over time, Investopedia’s mortgage calculator also shows a breakdown of your payments by the life of the loan.

Adjustable rate mortgage

If you take out a fixed-rate mortgage and pay only the amount due, your total monthly payment will remain the same for the life of the loan. The interest portion of your payment will gradually decrease as more of your payment is applied to the principal. But the total amount of your debt will not change.

However, this does not work for borrowers who take out an adjustable rate mortgage (ARM). They pay a set interest rate during the initial loan period. However, after a certain period of time—one or five years, depending on the loan—the mortgage “resets” to a new interest rate. Often the initial rate is set below the market rate at the time of borrowing and increases after it resets.

Your monthly payment may change on an adjustable rate mortgage because your outstanding principal is multiplied by a different interest rate.

Interest rate compared to annual percentage rate

When you receive a loan offer, you may come across a term called the annual percentage rate (APR). The APR and the actual interest rate the lender charges you are two different things, so it’s important to understand the difference.

Unlike an interest rate, an APR takes into account the total annual cost of obtaining a loan, including fees such as mortgage insurance, discount points, loan origination fees and some closing costs. It averages the total cost of borrowing over the life of the loan.

It’s important to understand that your monthly payment is based on your interest rate, not the annual percentage rate. However, lenders are required by law to disclose the loan estimate APR they provide after you apply so you can have a more accurate idea of ​​how much you’re actually paying to borrow that money.

Some lenders may charge you a lower interest rate but charge higher down payments, so including the APR helps provide a more holistic comparison of different loan offers. Because the APR includes applicable fees, it is higher than your actual interest rate.

The formula for calculating the principal and interest on a simple interest loan is: SI = P * R * T, according to which:

• P = principal or loan amount
• R = interest rate
• T = time or number of years of loan

Frequently asked questions (FAQ)

How is my interest payment calculated?

Lenders multiply your outstanding balance by the APR, but divide by 12 because you make monthly payments. So, if you owe $300,000 on your mortgage and your rate is 4%, you will initially owe interest of $1,000 per month ($300,000 x 0.04 ÷ 12). The rest of your mortgage payment is applied to your principal.

What is depreciation?

Mortgage amortization allows borrowers to make fixed payments on their loan even as their outstanding balance continues to decline. Initially, most of your monthly payment goes toward interest, with only a small percentage reducing the principal amount. It changes over time, with more of your monthly payment reducing your outstanding balance and a smaller percentage going toward interest.

What is the difference between an interest rate and an annual percentage rate?

The interest rate is the amount the lender actually charges you as a percentage of your loan amount. In contrast, the annual percentage rate (APR) is a way of expressing the total cost of borrowing. So the APR includes costs such as loan origination fees and mortgage insurance. Some loans offer a relatively low interest rate but have a higher APR due to other fees.

Bottom line

You probably know the monthly payment on your mortgage, car loan or personal loan. However, calculating how that money is divided between principal and interest can help you understand how much your loan will cost you and how it will be repaid. You can do the calculations yourself or use an online calculator.