Simplified Guide on How to Calculate Loan Payments

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Updated: May 17, 2024

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Taking on a loan is a significant financial commitment, so ensuring your monthly payments will be within your budget is important. You are less likely to fall behind if you know your loan's full terms and conditions before you start making payments. MoneyGeek's guide explains how these payments work, how to calculate them and the essential terminology.

Key Takeaways

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Calculating your monthly payments helps tailor your budget to ensure you efficiently meet your loan repayment requirements.

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Consider the principal, interest rate and loan terms to calculate your monthly loan payments.

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The formula for your monthly payments can change based on whether your loan is interest-only or amortizing.

How Loan Payments Work

Loan payments are your method of repaying borrowed money to the lender, typically every month. The payment includes the principal and interest over a set period until you repay the loan in full. Before taking out a loan, understand the factors that influence your monthly loan payments to ensure you can afford them:

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    Principal

    The principal is the initial amount you borrow. The larger your principal, the higher your monthly payment will be, as the loan repayment includes paying down this original sum and interest. For example, if you borrow $20,000 for a personal loan, your principal is $20,000.

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    Loan Term

    The term of your loan dictates how long you have to repay it. A longer loan term means smaller monthly payments spread over more time, while a shorter term means larger payments over a shorter period. Personal loan terms typically range from one to seven years, with two to five years being the most common range many lenders offer. Residential mortgage loan terms are typically 30 years.

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    Interest Rate

    The interest rate is the cost your lender charges for borrowing their money, and it significantly impacts your monthly payments. Factors like your credit score, debt-to-income ratio and loan repayment terms determine the interest rate.

How to Calculate Interest-Only Loan Payments

With an interest-only loan, all of your monthly payment goes toward the loan’s interest for a pre-set period. During this time, the principal remains unchanged. This is common in mortgages and home equity lines of credit with interest-only draw periods. You won’t typically find this option with personal loans.

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HOW TO ESTIMATE PAYMENT ON AN INTEREST-ONLY LOAN

The formula to calculate your monthly loan payment is: P = a (r / n)

Where:

  • P is your monthly loan payment
  • a is your principal
  • r is your interest rate
  • n is the number of payments you make each year (which is 12)

To use this formula, divide your interest rate by the number of payments you make in a year (usually 12). Multiply this result by your principal to find out your monthly loan payment.

For instance, you take out a $50,000 mortgage and receive a 5% interest rate. Your interest-only period lasts five years. You can use the formula to determine how much you'll need to pay back each month.

  1. Divide your interest rate by the number of payments in a year (12) to get your monthly interest rate:

    0.05 ÷ 12 = 0.0041667

  2. Then, multiply this monthly interest rate by your principal amount to calculate your monthly payment:

    $50,000 × 0.0041667 = $208.335

Your monthly payment for the interest-only period comes out to be approximately $208.

When the interest-only period of your loan ends, you'll start paying off the principal in addition to the interest — that means your payments will go up. You might consider paying off the remaining balance in a lump sum or refinancing your mortgage for a potentially lower interest rate.

How to Calculate Amortizing Loan Payments

Amortizing loans are installment loans where you're required to make regular payments over a predetermined period. Each payment is split into two parts: one portion reduces your principal balance, and the other covers the interest on the loan. Common examples of amortizing loans are personal loans and auto loans.

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HOW TO CALCULATE AMORTIZING LOAN PAYMENTS

To calculate your monthly payment for an amortizing loan, use the following formula:

P = a ÷ { [ (1 + r)^n ] - 1 } ÷ [ r (1 + r)^n]

Where:

  • P represents your monthly loan payment
  • a is the principal amount
  • r is your periodic interest rate, which is the annual interest rate divided by 12 to give you a monthly rate
  • n is the total number of months over which you will repay the loan

To use this formula, determine your loan's principal amount and the annual interest rate, then convert that interest rate into a monthly rate by dividing it by 12. Next, figure out the total duration of your loan in months. By inserting these values into the formula, you can calculate the exact monthly payment amount.

Imagine you take out a $25,000 personal loan with a 5-year term and a 10% interest rate, lower than the current 12.49% average interest rate for a 24-month personal loan. You can calculate your monthly payment using the formula.

  1. Calculate the periodic interest rate (r) by dividing the annual interest rate by 12:

    0.10 ÷ 12 = 0.00833

  2. Then, determine the total number of months (n) in the loan term:

    5 x 12 = 60

  3. Next, plug in the values into each group of the equation:

    ([ (1 + r)^n ] - 1) = [(1 + .00833)^60] - 1 = 0.6453

    [ r (1 + r)^n] = [(.0083*(1+.00833)^60] = 0.0137

  4. Divide the results from step 3:

    0.6453 ÷ 0.0137 = 47.065

  5. Finally, divide the principal amount by the result obtained in step 4:

    $25,000 ÷ 47.065 = $531.18

That means, for the $25,000 personal loan at a 10% annual interest rate over a 5-year term, your monthly payment is approximately $531.18.

Use Our Calculator to Calculate Your Loan Payment

Before taking out a loan, use our loan calculator to fully understand your financial commitment. Simply enter your loan amount, interest rate and term length to quickly get a detailed overview of your potential monthly payments along with a comprehensive amortization schedule.

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Estimate the monthly payment for your loan.

Updated: Jul 12, 2024

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How to Save Money on Loan Interest Payments

Finding ways to reduce the interest you pay on a loan can lead to significant savings over the long term. Here are some strategies to help you pay less in interest:

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    Compare lenders

    Shop around and compare offers from different lenders to find the lowest interest rates. A lower rate means less interest to pay over the life of your loan. Also look at different loan type options, such as fixed vs. variable rates and secured vs. unsecured loans.

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    Improve your credit score

    A higher credit score can qualify you for lower interest rates. Take steps to improve your credit by paying bills on time and reducing your debt.

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    Reduce your loan term

    Choosing a shorter loan term means higher monthly payments, but you'll pay less interest overall. This strategy can save you money if you can afford the higher monthly outlay.

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    Make additional payments

    Paying more than the minimum due each month reduces your principal balance faster, decreasing the amount of interest you accrue.

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    Pay off your loan early

    If possible, paying off your loan before its term ends can save you on the interest that would have been accumulated. That said, check if your loan has any prepayment penalties before doing so.

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REFINANCING A LOAN CAN MAKE SENSE

Refinancing can potentially allow you to get a better interest rate on your loan under the right circumstances:

  1. If market interest rates have decreased significantly since you originally took out your loan, you may be able to refinance into a new loan with a lower rate. This can reduce the total interest paid over the remaining life of the loan.
  2. If your credit score and income have improved, you may qualify for a loan with a better interest rate than your original loan terms.
  3. If refinancing lets you change your repayment timeline. You could refinance into a shorter-term loan to pay less total interest or extend the term for lower monthly payments.

Before refinancing, consider refinancing costs, such as processing fees or penalties for early repayment of your existing loan. — Alvin Yam, CFP

FAQ About Loan Payments

We answered some frequently asked questions about loan payments to help you manage your finances.

What happens if I miss a loan payment?
Is it better to choose a longer or shorter loan term?
What is an amortization schedule?
Can I refinance my loan to get a better interest rate?
What is a prepayment penalty?
What happens if I default on my loan payments?
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The content on this page is accurate as of the posting/last updated date; however, some of the rates mentioned may have changed. We recommend visiting the lender's website for the most up-to-date information available.

Editorial Disclosure: Opinions, reviews, analyses and recommendations are the author’s alone and have not been reviewed, endorsed or approved by any bank, lender or other entity. Learn more about our editorial policies and expert editorial team.