Before you take out a bank loan, you need to know how your interest rate is calculated and understand how to calculate it yourself.
There are various methods banks use to calculate interest rates, and each method will change the amount of interest you pay. If you know how to calculate interest rates, you will better understand your loan contract with your bank. You also will be in a better position to negotiate your interest rate.
When a bank quotes you an interest rate, it's quoting what's called the effective rate of interest, also known as the annual percentage rate (APR). The APR is different than the stated rate of interest, due to the effects of compounding interest.
Banks may also tie your interest rate to a benchmark, usually the prime rate of interest. If your loan includes such a provision, your interest rate will vary, depending on fluctuations in this benchmark.
Calculating Interest on a One-Year Loan
If you borrow $1,000 from a bank for one year and have to pay $60 in interest for that year, your stated interest rate is 6%. Here's the calculation:
Effective Rate on a Simple Interest Loan = Interest/Principal = $60/$1,000 = 6%
Your annual percentage rate or APR is the same as the stated rate in this example because there is no compound interest to consider. This is a simple interest loan.
Meanwhile, this particular loan becomes less favorable if you keep the money for a shorter period of time. For example, if you borrow $1,000 from a bank for 120 days and the interest rate remains at 6%, the effective annual interest rate is much higher.
Effective rate = Interest/Principal X Days in the Year (360)/Days Loan Is Outstanding
Effective rate on a Loan with a Term of Less Than One Year = $60/$1,000 X 360/120 = 18%
The effective rate of interest is 18% since you only have use of the funds for 120 days instead of 360 days.
Effective Interest Rate on a Discounted Loan
Some banks offer discounted loans. Discounted loans are loans that have the interest payment subtracted from the principal before the loan is disbursed.
Effective rate on a discounted loan = [Interest X Days in the Year (360)/Days Loan is Outstanding] / [Principal - Interest]
Effective rate on a discounted loan = (60 X 360/360)/($1,000 - 60) = 6.38%
As you can see, the effective rate of interest is higher on a discounted loan than on a simple interest loan.
Effective Interest Rate With Compensating Balances
Some banks require that a small business applying for a business bank loan hold a balance, called a compensating balance, with their bank before they will approve a loan. This requirement makes the effective rate of interest higher.
Effective rate with compensating balances (c) = Interest/(1-c)
Effective rate compensating balance = 6%/(1 - 0.2) = 7.5 percent (if c is a 20 percent compensating balance)
Effective Interest Rate on Installment Loans
Many consumers have installment loans, which are loans that are repaid with a set number of payments. Most car loans are installment loans, for example.
Unfortunately, one of the most confusing interest rates that you will hear quoted on a bank loan is that on an installment loan. Installment loan interest rates are generally the highest interest rates you will encounter. Using the example from above:
Effective rate on installment loan = 2 X Annual # of payments X Interest/(Total no. of payments + 1) X Principal
Effective rate/installment loan = (2 X 12 X $60)/(13 X $1,000) = 11.08%
The interest rate on this installment loan is 11.08%, as compared to 7.5% on the loan with compensating balances.