Quick Answer
Loan interest is the cost charged by a lender for borrowing money. The amount of interest depends on factors such as the principal, interest rate, tenure and the method used to calculate interest.
For loans with reducing-balance repayment, interest is generally calculated on the outstanding principal, so the interest portion can decrease as the loan is repaid.
What Is Loan Interest?
Loan interest is the amount a borrower pays to a lender in addition to repaying the principal amount borrowed. It is one of the main components of the total cost of a loan.
The interest charged on a loan can depend on the amount borrowed, the annual interest rate, the repayment period and whether the lender uses a simple, flat-rate or reducing-balance method.
Loan Interest Formula
For a simple-interest calculation, the basic formula is:
P = Principal, R = Annual interest rate as a decimal, T = Time in years
If the annual rate is given as a percentage, convert it to a decimal before using the formula. For example, 10% becomes 0.10.
How Principal, Rate and Tenure Affect Interest
| Factor | Effect on borrowing cost |
|---|---|
| Principal | A larger amount borrowed generally means more interest in absolute terms. |
| Interest rate | A higher rate generally increases the interest charged. |
| Tenure | A longer repayment period can increase total interest, even though the periodic payment may be lower. |
Example: Calculating Simple Loan Interest
Suppose you borrow ₹1,00,000 at an annual interest rate of 10% for 2 years under a simple-interest calculation.
Principal (P): ₹1,00,000
Rate (R): 10% = 0.10
Time (T): 2 years
The total amount to be repaid under this simple-interest example would therefore be:
Reducing-Balance Loan Interest
Many instalment loans use a reducing-balance method. Under this approach, interest is calculated on the outstanding principal rather than the original principal for the entire tenure.
As each repayment reduces the outstanding principal, the interest component of later payments can become smaller. The exact calculation depends on the loan's repayment schedule and terms.
Monthly Rate
When a loan has a quoted annual interest rate and monthly repayments, a monthly rate may be represented as the annual rate divided by 12 when the loan terms use that convention.
Flat Rate vs Reducing Balance
Loan interest can be quoted or calculated using different methods. A flat-rate calculation applies the stated rate to the original principal for the relevant period, while a reducing-balance calculation bases interest on the outstanding balance.
| Method | Interest basis |
|---|---|
| Simple interest | Principal × rate × time |
| Flat rate | Typically based on the original principal for the stated period |
| Reducing balance | Based on the outstanding principal |
How to Calculate Loan Interest Step by Step
- Find the principal: Identify the amount you are borrowing.
- Find the interest rate: Check the annual rate stated in the loan terms.
- Check the tenure: Determine how long the loan will remain outstanding.
- Identify the interest method: Check whether the loan uses simple, flat-rate or reducing-balance calculations.
- Apply the appropriate formula: Use the calculation method specified by the lender.
- Check the total repayment: Add principal and applicable interest, along with any separate fees or charges when assessing the overall borrowing cost.
Loan Interest and EMI
For an EMI-based loan, the monthly instalment generally contains both principal and interest. In a reducing-balance loan, the interest portion is calculated from the outstanding principal, while the principal portion increases as the balance falls.
For a fixed monthly EMI, total interest can therefore be found by comparing the total of all scheduled EMI payments with the original principal, subject to the loan's exact terms and excluding separate fees and charges.
What Else Should You Check?
The interest rate is not always the only cost of borrowing. When comparing loans, review the repayment schedule, processing fees, prepayment conditions, late-payment charges and other applicable costs in the lender's terms.