If you aren’t quite sure how interest is calculated on your personal loan, it may come as a surprise learning that monthly interest charges vary even on fixed rate loans.
Each month when you make your personal loan repayment, you may notice that the proportion of the repayment that goes towards interest charges typically changes from one month to the next.
This can be particularly confusing if you have a fixed rate personal loan, as you might have expected that a fixed interest rate means fixed interest payments. But, there’s a fairly simple explanation as to why this is the case.
It comes down to two main factors:
1. Interest is calculated daily and typically charged monthly.
Since the number of days in a month can change from one to the next, interest charges may be slightly higher in the longer months and lower in the shorter months.
2. Interest is charged on the principal balance.
The reason you will likely see your monthly payable interest gradually decrease over the life of your loan is because it is charged as a percentage of the amount owing. As you make repayments on your loan, you pay down the principal balance, thus reducing the amount owing on the loan.
Take Claudia, for example. Claudia decides to take out a personal loan to help cover the cost of furnishing her new home. After comparing loans and applying for her preferred product, she gets approved for a $15,000 loan with a fixed interest rate of 8 per cent and a loan term of three years.
Claudia’s monthly repayments are estimated to be $470. To figure out roughly how much of her first monthly repayment will go towards interest, she divides her interest rate by 12 (as interest rates are annual figures), and then multiplies it by her loan’s principal amount of $15,000.
- Her equation looks like this: (0.08/12) x 15,000 = 100
This means that of her $470 repayment, $100 would cover interest charges and the remaining $370 would go towards paying down the principal balance.
If Claudia wanted to find out how much interest she would pay on her second repayment, she could use the same equation but with the remaining principal balance. As she will have paid it down by $370, the principal in her second month would be $14,630
- Her equation would look like this: (0.08/12) x 14,630 = 97.53
As you can see, the interest charged in her second month of loan repayments is slightly less than her first month, due to the reduced principal balance. Keep in mind that these are approximate figures only, to show how interest is charged and can vary from one month to the next.
Here’s how the interest charges on Claudia’s first six months of repayments might look:
|Principal balance||Repayment amount||Interest charged||Principal paid||Updated balance|
Source: RateCity.com.au. Notes: This is an example only for the purpose of illustrating variations in interest.
How does interest vary on variable rate personal loans?
If your personal loan has a variable interest rate, the amount of interest you pay will not be fixed in advance and may instead be raised or lowered by your lender in accordance with the current economic conditions.
Calculating your interest charges on a variable rate personal loan can be trickier, but the calculations work much the same based on the interest rate at the time.