What is interest
When you take out a loan, whether it’s a car loan, home loan or amount on a credit card, you’ll have to pay back both the amount you borrowed and interest on top of it. But what do we mean by that?
Essentially, interest is a fee you pay for using someone else’s (usually the bank’s) money. It’s how lenders make profit from giving out loans – after all, they’re not in it out of the goodness of their hearts.
Usually the repayments you make on a loan will be made up of two parts: the part that reduces your balance to pay off your loan, and the part that covers the interest on the loan.
Factors that affect how much interest you pay
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You’ll need to know a few basic facts about your loan before calculating how much interest you’ll pay. All of these things should be freely available to you before you take on the loan, and it’s a good idea to know them all, even if you’re not trying to calculate interest.
This is the amount you’re looking to borrow. But it’s not as simple as deciding how much you want – you should really be focusing on how much you can realistically afford to pay back.
To work it out, consider your budget on all levels – yearly, monthly and weekly – and think about any life changes you might encounter, like having kids or moving house. Mozo also has some great, free resources to help you straighten out just how much you can borrow, like our:
- Budget calculator
- Savings calculator
- Borrowing calculator
How long will you be repaying your loan? Shorter loan terms will generally mean higher repayments, but less interest in the long run. Longer terms will lower monthly repayments, but cost more in interest over the life of the loan.
For example, our personal loan repayment calculator shows that on a loan of $20,000 at 8.75% p.a. you would pay:
- $634 each month, adding up to $2,812 in interest over 3 years, or
- $413 each month, adding up to $4,765 in interest over 5 years.
On many loans, you’ll have the option to make repayments weekly, fortnightly or monthly. Which one you choose will depend on your budgeting style.
More repayments means less interest, because of the effects of compounding, so weekly repayments will save you some money. But before you commit to a weekly repayment schedule, make sure your budget can meet it.
When you make your repayment, not all of it goes to paying off your loan, as such. A certain amount will go towards paying the interest first and then what’s left chips away at your loan principal. Because the amount of interest you pay depends on what your principal is, to calculate ongoing interest costs, you’ll need to know what amount you’re making in repayments.
When calculating interest on your loan, remember to use the basic annual interest rate and not the comparison rate to get accurate numbers. The comparison rate takes into account fees and charges as well as interest, so if you use it, you will get a higher amount of interest than you should.
Calculating interest on a car, personal or home loan
These loans are called amortizing loans. The mathematical whizzes at your bank have worked them out so you pay a set amount each month and at the end of your loan term, you’ll have paid off both interest and principal.
You can use an interest calculator to work out how much interest you’re paying all up, or, if you’d rather do it by hand, follow these steps: