How To Calculate Loan Interest: Simple And Amortized
When you take out a personal loan in India, one of the most important things to understand is how the interest on your loan is calculated. The interest you pay on a loan determines how much extra you’ll pay in addition to the amount you borrowed.
Knowing how to calculate loan interest can help you plan your finances better and avoid surprises. In this blog, we’ll explain the two main types of interest calculation methods used in India: Simple Interest and Amortized Interest.
What is a Personal Loan?
Before we get into the details of interest calculation, let’s quickly recap what a personal loan is. A personal loan is a type of unsecured loan, which means you don’t need to provide any collateral or security to get the loan. Personal loans are commonly used for various purposes like medical emergencies, weddings, home renovations, or even vacations.
Banks and financial institutions offer personal loans with different terms, including varying interest rates and repayment periods. It’s important to compare personal loan interest rates in India before choosing a lender, as even a small difference in the rate can significantly affect the total cost of the loan.
Understanding Simple Interest
Simple interest is one of the most straightforward ways to calculate loan interest. It is calculated only on the original amount borrowed (called the principal) and does not take into account any repayments you make during the loan tenure.
The formula for calculating simple interest is:
Simple Interest (SI) = (Principal × Rate of Interest × Time) / 100
Let’s break it down with an example:
Suppose you take a personal loan of ₹1,00,000 at an interest rate of 10% per annum for a period of 3 years.
- Principal (P): ₹1,00,000
- Rate of Interest (R): 10% per annum
- Time (T): 3 years
Using the formula:
SI = (1,00,000 × 10 × 3) / 100 = ₹30,000
So, the total interest you would pay over 3 years is ₹30,000. The total amount to be repaid would be ₹1,30,000 (Principal + Interest).
Understanding Amortized Interest
Amortized interest is more commonly used for loans like personal loans, home loans, and car loans. In this method, the interest is calculated on the outstanding loan balance, which decreases as you make your EMI payments. That means that with each payment, a portion goes towards paying off the interest, and the remaining amount reduces the principal.
The process of calculating amortized interest can be a bit complex because the interest amount decreases over time as the principal decreases. Here’s a simplified explanation:
Let’s say you take a personal loan of ₹1,00,000 at an interest rate of 10% per annum for 3 years, and you’re required to pay monthly EMIs.
The first EMI will be calculated on the full principal amount, but as you pay off part of the loan, the principal decreases, and so will the interest on the remaining balance. Over time, more of your EMI goes towards reducing the principal, and less goes towards interest.
To calculate the EMI for an amortized loan, you can use the following formula:
EMI = [P × R × (1+R)N] / [(1+R)N – 1]
Where:
- P is the principal loan amount
- R is the monthly rate of interest (yearly rate divided by 12)
- N is the count of monthly instalments
Let’s apply this formula to the previous example:
- Principal (P): ₹1,00,000
- Annual Interest Rate: 10% (which is 0.10 when divided by 100)
- Monthly Interest Rate (R): 0.10 / 12 = 0.00833
- Loan Tenure (N): 3 years, which is 36 months
Plugging in these values:
EMI = [1,00,000 × 0.00833 × (1+0.00833)36] / [(1+0.00833)36 – 1]
Using a personal loan EMI calculator simplifies this process significantly. These calculators are available on most bank websites and financial portals, where you can enter your loan amount, interest rate, and tenure to instantly see your EMI.
Wrapping Up
Whether you’re looking for a personal loan to cover unexpected expenses or to fund a major purchase, understanding how interest is calculated is crucial. Simple interest offers a straightforward calculation, but amortized interest provides a more accurate picture of your loan payments over time. By using tools like a personal loan EMI calculator, you can make informed decisions that help you manage your finances effectively.
