Interest on Loan

What is Interest on Loan?

The term “interest on loan” refers to the amount that a borrower is obligated to pay or a depositor is supposed to earn on a principal sum at a pre-determined rate, which is known as the rate of interest and the formula for interest can be derived by multiplying the rate of interest, the outstanding principal sum and the tenure of the loan or deposit.

where,

• P = Outstanding principal sum
• r = Rate of interest
• t = Tenure of loan / deposit

In case of periodic interest payment (such as monthly, quarterly, etc), the equation for interest payment can be derived by multiplying the rate of interest and the outstanding principal sum and then dividing the result by the number of periodic payments during the year.

Mathematically, Interest Payment is represented as,

where,

• P = Outstanding principal sum
• r = Rate of interest
• N = Number of periodic payment per year

Steps to Calculate Interest on Loan

• Step 1: Firstly, figure out the outstanding principal sum of the loan or deposit and it is denoted by ‘P’. Please keep in mind that the outstanding principal is the balance at the beginning of the year.
• Step 2: Next, figure out the rate of the interest rate for the given loan or deposit which is denoted by ‘r’.
• Step 3: Next, figure out the tenure of the loan or deposit and it is denoted by ‘t’. The tenure of the facility is the number of years remaining until its maturity.
• Step 4: Finally, the interest can be derived by multiplying the outstanding principal sum (step 1), the rate of interest (step 2) and the tenure of the loan or deposit (step 3) as shown below,

Examples

Example #1

Let us take an example Trevor who has deposited his money at ABC Bank Ltd. As per the bank policy, Trevor has been offered an interest rate of 6% on a sum of $1,000 that has been deposited for a period of 3 years. Calculate the interest to be earned by Trevor at the end of 3 years.

Solution:

Given,

• Outstanding principal sum, P = $1,000
• Rate of interest, r = 6%
• Tenure of deposit, t = 3 years

Use the following data for the calculation of interest.

The interest earned by Trevor can be calculated as,

Interest = $1,000 * 6% * 3

Interest will be –

Interest = $180

Therefore, Trevor will earn an interest of $180 at the end of 3 years.

Example #2

Let us take another example of Smith who has borrowed a sum of $5,000 from XYZ Bank Ltd for a period of 3 years. The rate of interest charged for the facility is 8% and the loan has to be repaid in 6 equal half-yearly payments of $954. Calculate the interest on loan to be paid by Smith at the end of 1^st year, 2^nd year and 3^rd year.

Solution:

Given,

• Outstanding principal sum, P = $5,000
• Rate of interest, r = 8%
• Number of payments per year, N = 2 (since half-yearly payments)

Use the following data for calculation of interest charged for 1st six months.

So, calculation of interest charged for 1st six months can be done as follows –

Interest Charged for 1st Six Months = $5,000 * 8% / 2

Interest Charged for 1st Six Months will be –

Interest Charged for 1st Six Months = $200

Calculation of Outstanding Principal Sum after 1^st Six Months will be –

Outstanding Principal Sum after 1^st Six Months will be –

Outstanding principal sum after 1^st six months = $5,000 – ($954 – $200)

Outstanding Principal Sum after 1^st Six Months = $4,246

Similarly, we can do the calculation of outstanding principal and interest charged for months 1 to 5.

Interest on Loan Calculator

You can use the following Interest Formula Calculator

Relevance and Uses

The calculation of interest is an important concept to understand because it is an indispensable part of the income statement of any company. It can either impact the income side in the form of interest earned on an investment or affect the cost in the form of interest expense charged on the debt. As such, a company should employ adequate resources for settling down on the interest of both invested (return on investment) and borrowed funds (cost of the fund) in order to manage the financial performance efficiently.

Recommended Articles

This has been a guide to Interest on Loan. Here we learn how to calculate interest on loan using its formula along with practical examples, calculator and downloadable excel template. You can learn more about financial analysis from the following articles –

• ROI
• Formula of Nominal Interest Rate
• Loan Note
• Amortized Loan
• Normalization Formula