August 4, 2016

Calculating Loan Interest Rates with Simple & Compound Interest

Whether you borrow money for a home, or auto, or use a credit card to pay for expenses such as gas and groceries, your bank charges interest on the unpaid balance you carry. Based on interest rates, lenders make revenue on the interest they charge to borrow from their financial institution. Depending on the type of credit you obtain, the rates and dollar amounts will be calculated based on a particular formula.

Understanding how lenders apply mortgage interest rates today and how they calculate current interest rates on loans is important when managing your personal finances and credit. The type of credit product you obtain when borrowing from the lender and the length of time the money is needed will play a large part in the way interest is compounded and calculated. A simple interest personal loan or mortgage contract will vary from that of a compound interest loan.

Understanding Simple Interest VS Compound Interest

While simple interest and compound interest are each calculated based on interest rates charged for borrowing money, they are each calculated differently when applied to the loan.

Simple interest is calculated solely on the principal you borrow from the lender. Compound interest is based however on the principal, plus any interest that has been added to the loan. Simple interest is generally calculated for short-term loans or accounts only. Compounded interest is used for long-term loans such as mortgages or home equity loans. Compounded interest adds up exponentially at a much faster rate than simple interest where the growth of money is slower and more constant.

Calculating Mortgage Interest Rates

While an interest rate calculator can be useful in determining the money you will be charged on a mortgage loan, the basic method of figuring the amount is fairly straightforward. The federal government sets forth guidelines to ensure lenders follow specific protocol when applying interest rates as well, federalreserve.gov.

The monthly mortgage payment calculated using either the simple interest or compound interest method remains the same. Using a $300,000 mortgage loan for example, with a term of 30 years at mortgage interest rates today of 4%, will yield a monthly payment of $1,432.25, whether it is a simple interest loan or a compound interest loan.

Simple Interest Calculation

Using a $300,000 mortgage at current mortgage interest rates of 4% with a monthly payment of $1,432.25, divide the annual interest rate by the number of days in the year, (365) and add it to the mortgage balance. In the case of the $300,000 loan, the daily interest rate would be .04 divided by 365. This figure, (0.010959%) applied to the $300,000 balance equals $32.88 per day. The mortgage lender applies this amount each day until a payment is made. Once it is made, a new interest charge is added based on the new principal that has been reduced.

Compound Interest Calculation

Using a compound mortgage interest method, charges are calculated monthly. The rate that is applied to the principal would be .04 divided by 12, which equals 0.333333%. This results in an interest charge of $300,000 times 0.00333333 or $1,000. This process is repeated for another month on the new mortgage balance after the monthly mortgage payment is added to the interest and principal.

The way in which interest is calculated and applied to a loan or credit card is important in determining the monthly payment amount as well as the overall cost of borrowing the principal. Learning the method lenders and creditors use to apply interest is critical in comparing loans or other credit products. BestCredit.net provides you with all of the information needed to check great rates, calculate payments, and save money on credit cards and loans.