How to calculate loan interest: methods, formulas and worked examples

Every loan product is built on an interest calculation method, and the method changes what the borrower pays far more than most people expect. Two loans quoted at "12%" can cost very different amounts. This guide explains the five methods lenders actually use, gives the formula for each, and works the same example through all of them so you can see the difference in real numbers.

All the examples use the same loan: 1,000 borrowed for 12 months at 12% a year, repaid in 12 monthly installments. The currency does not matter; the arithmetic is the same.

The five methods at a glance

How do you calculate simple interest?

Simple interest is the easiest formula, and the foundation for the rest:

Interest = Principal × Rate × Time

For 1,000 at 12% a year for one year, interest is 1,000 × 0.12 × 1 = 120. For three years it is 1,000 × 0.12 × 3 = 360. The rate and the time must use the same unit: a 12% annual rate over 6 months uses a time of 0.5 years.

Simple interest never charges interest on interest. That makes it predictable and easy to explain to a borrower, which is why it is common in short loans and group lending. The catch is that "simple interest" describes the interest, not how the borrower repays. A loan can charge simple interest and still be repaid in installments, and how you structure those installments decides whether it behaves like a flat or a reducing balance loan.

How does flat rate interest work?

Flat rate interest calculates interest once, on the original principal, for the full term, and then divides the total by the number of installments.

• Interest = 1,000 × 12% × 1 year = 120
• Total to repay = 1,000 + 120 = 1,120
• Monthly installment = 1,120 ÷ 12 = 93.33

The borrower pays 120 in interest even though they are repaying principal every month, so for most of the year they owe less than 1,000 but are still being charged as if they owed the full amount. That is why flat rate loans look cheap when quoted and cost much more than the number suggests. On this loan the true annual cost is about 21.5%, not 12%. Our guide to the effective interest rate on flat rate loans shows how to work that out.

Flat rate is popular because it is simple to explain and to compute by hand. If you offer flat rate loans, quote the total cost in currency as well as the rate, so borrowers can compare offers honestly.

How does reducing balance interest work?

With reducing balance (also called declining balance) interest, each period's interest is charged only on the balance still owed. As the borrower pays down principal, the interest charge shrinks.

For equal installments, the payment comes from the standard annuity formula:

Payment = P × r ÷ (1 − (1 + r)^−n)

where P is the principal, r is the interest rate per period (12% a year is 1% a month), and n is the number of periods.

For our loan: 1,000 × 0.01 ÷ (1 − 1.01^−12) = 88.85 a month, so the borrower repays 12 × 88.85 = 1,066.19, of which 66.19 is interest.

In the first month, interest is 1,000 × 1% = 10.00, so 78.85 of the 88.85 payment reduces principal and the balance falls to 921.15. In month two, interest is 9.21 on the lower balance, so more of the payment goes to principal. By month 12 interest is 0.88. Our guide to loan amortization schedules sets out the full table.

There is a second common variation, equal principal. Principal is divided evenly (1,000 ÷ 12 = 83.33 a month) and interest is charged on the falling balance, so the payments start higher and decline: 93.33 in month one, 92.50 in month two, 91.67 in month three. Total interest is 65.00, slightly less than equal installments because principal is repaid faster.

What are interest-only loans?

An interest-only loan charges interest each period on the full principal and repays the principal in one amount at the end.

• Interest each month = 1,000 × 1% = 10.00
• Total interest over 12 months = 120.00
• Principal of 1,000 is due at month 12

The monthly payments are the smallest of any method, which suits borrowers with lumpy income or a bridge to a known payment. The risk is the balloon at the end: if the borrower cannot repay the principal, the lender must refinance or collect. Lenders using interest-only should be careful about term and security.

How does compound interest work?

Compound interest charges interest on the principal plus any interest already added. The formula for a lump sum is:

Amount = P × (1 + r)^n

With 12% a year compounded monthly, 1,000 grows to 1,000 × 1.01^12 = 1,126.83 after a year, so interest is 126.83, higher than simple interest's 120 because each month's interest itself earns interest.

Over longer periods the gap widens. After three years, simple interest at 12% is 360; compounded annually it is 404.93; compounded monthly it is 430.77. Compounding is standard for savings and deposits and appears in lending when interest accrues and is added to the balance, for example on a loan repaid in a single lump sum.

The same loan, five ways

Here is the same 1,000, 12-month, 12% loan under each method:

The rate on the label is identical, yet the flat rate loan costs nearly twice the interest of the reducing balance loan. This is the single most important idea in loan pricing: the calculation method matters as much as the rate.

You can test your own numbers in the loan calculator, or compare the two most common methods side by side in the flat vs reducing balance calculator.

Interest periods, nominal and effective rates

Loans quote rates per day, week, month, year or loan cycle. To compare them, convert to a common basis.

• A rate of 1% a month is a nominal rate of 12% a year, because 1% × 12 = 12%.
• The effective annual rate accounts for compounding: 1% a month compounded is (1.01^12 − 1) = 12.68% a year.
• Some lenders calculate daily interest using 365 days a year, others 360. The difference is small but should be stated in the loan agreement.

When a rate is quoted without saying "per month" or "per year," ask. Confusing the two is a common source of disputes.

How fees change the real cost

Interest is not the only cost. A processing fee, an insurance charge or an admin fee raises the real cost of a loan, and how the fee is collected matters. A fee deducted at disbursement reduces the cash the borrower receives while the repayments stay the same. A fee added to the loan balance is repaid with interest.

On our example, a 5% fee (50) deducted from a reducing balance loan means the borrower receives 950 but still repays 88.85 a month, which lifts the annualized cost of the loan from 12% to roughly 21.9%. If the same fee is added to the loan instead, the installment becomes 93.29 and the total repaid 1,119.49. Read more in deductible vs capitalized loan fees.

Which method should you choose?

• Reducing balance is the fairest to borrowers and the easiest to defend to regulators. It is the usual choice for larger, longer loans.
• Flat rate is simple, but the true cost is higher than the label suggests. If you use it, disclose the total cost and consider whether the borrower could compare it fairly.
• Interest-only suits short bridging loans with a clear repayment source and good security.
• Compound suits accruing loans repaid in a lump sum, and deposits.

Whatever you choose, apply it consistently per product, write it in the loan agreement, and make sure your software calculates it the same way you quote it. Local law may restrict methods, rate caps or disclosure, so check before you set products.

Calculating loan interest in LoanTabs

LoanTabs lets you set the interest method on each loan product: flat, declining balance, reducing balance (equal installments or equal principal), interest-only, or compound interest (accrued or equal installments). Interest can be a percentage or a fixed amount, charged per day, week, month, year or loan cycle. You can set minimum, default and maximum interest so officers cannot go outside policy.

When you create a loan, a live schedule preview shows every installment before you save, so you can check the numbers with the borrower. Read more on the loan origination and servicing features page, or see loan origination for how products and schedules fit into the application workflow.

Common mistakes when calculating loan interest

• Mixing units. Using an annual rate with a monthly period, or the reverse, makes interest twelve times too high or too low.
• Quoting only the flat rate. A "10% flat" loan is not a "10% loan." Show the total repaid.
• Ignoring fees. A cheap rate with a large upfront fee can cost more than a higher rate with none.
• Rounding schedules inconsistently. Round each installment the same way and put any difference in the final payment.
• Forgetting partial and late payments. Decide in advance how a short payment is allocated. See repayment allocation order.
• Not testing with a real example. Run a sample loan through your method and check it against a spreadsheet before you offer it.

FAQ

What is the formula for loan interest?

For simple interest it is Interest = Principal × Rate × Time. For a reducing balance loan with equal installments, the payment is P × r ÷ (1 − (1 + r)^−n), where r is the rate per period and n the number of periods. Interest each period is the rate times the current balance.

What is the difference between flat rate and reducing balance interest?

Flat rate charges interest on the original principal for the whole term. Reducing balance charges interest only on the amount still owed. For the same headline rate, flat rate costs the borrower considerably more. Our guide to flat rate vs reducing balance interest compares them in detail.

How do I calculate monthly interest on a loan?

Divide the annual rate by 12 to get the monthly rate, then multiply it by the outstanding balance. On a 12% annual loan with a balance of 1,000, monthly interest is 1,000 × 1% = 10.

Is compound interest used on loans?

Yes, where interest accrues and is added to the balance, such as a loan repaid in one lump sum. Most installment loans use reducing balance or flat rate rather than compounding into the schedule.

Which interest method does LoanTabs support?

LoanTabs supports flat, declining balance, reducing balance (equal installments or equal principal), interest-only and compound interest, set per loan product.