Jargon Friday: How To Calculate Interest On A Loan
We are introducing a new section on the blog, Jargon Friday, to appear every Friday (rather obvious isn’ t it?). Jargon Friday aims to simplify some finance and tax terms, and make it easier for a non finance reader to understand our posts, and even more, manage their finances better.
In this edition of Jargon Friday, we look at the term: Loan Interest.
Definition: Interest is the cost of borrowing money from the bank or any other source. Interest is quoted as an annual percentage, and is calculated against the money borrowed, over the period which the loan remains unpaid.
How To Calculate Loan Interest
Interest on loan is structured in two ways:
1. Straight-line interest: This is calculated upfront, and divided equally over the term of the loan. Using The 50,000 Bob Problem example, straight line interest is calculated as follows:
Interest = Principal * Interest Rate*Time in Years (I=PRT)
Principal = 50,000
Rate = 12%
Time = 1
Interest = 50,000*12/100*1
Interest = Kshs 6,000
To calculate the amount you would be required to pay per month, you add the Interest to the Principal and divide by the number of months in a year as follows:
50,000 + 6,000 = 56,000
56,000 / 12 = 4,667
I hope the math so far isn’t too bad.
2. Reducing Balance Interest: Under the Reducing Balance, you only pay interest on the unpaid portion of the loan each month, which means interest is recalculated each time a payment is due. The calculation method is a bit more complicated than the straight line method,and since this blog is about simplifying finance, I’ll outline the easiest way to do this using Microsoft Excel.
Go to Ms Excel, Open New Document. On the window that opens, choose Loan Armotization as shown below:
Once it opens, fill in the details of the loan as follows:
Loan Amount : 50,000
Interest Rate: 12%
Loan Period: 1
Number of payments per year: 12
Start Date of Loan: 1/1/12 (What I used)
Once you have input the details above, Excel produces a loan payment schedule that looks like this:
As you can see above, the monthly repayments by reducing balance come to Kshs 4,442.44, and the total interest is actually less than the interest we got using the straight line method. This is because each month, the interest due is calculated on the unpaid balance as opposed to on the total loan amount of Kshs 50,000.
The Armotization Form in Excel is a fantastic tool to use even for loans that exceed 1 year, you just adjust the metrics accordingly.
That’s all for now, happy calculating!
