How to calculate interest on consumer loans

Ever wonder why almost every time you make your car payment, the amount that you pay in interest is different? How is interest calculated anyway?

Most consumer loans accrue interest Per Diem; every day that you have an outstanding balance, you pay a 'fee' or interest for use of the money.

Let's say that you have a car loan. The balance owed is $15,500. You have low rate of 5.25%. Your payment is $400 per month.

Your payments are due on the last day of the month. You made you last payment on March 31, and you're going to the bank to give them your April 30 payment today. A total 40 days have passed. How much of your payment will go to interest, and how much towards the principal balance?

There are a number of ways to figure this out. I believe the following is the easiest method.

Step 1 - multiply the current balance by the interest rate.

$15,500 x 5.25% = $813.75

Step 2 - Divide the result from Step 1 by 365 (the number of days in a normal year)

$813.75 / 365 = $2.229 This is your daily interest charge, the fee you are charged each day for the use of the $15,500

Step 3 - Multiply the daily interest charge by the number of days since you last made a change to the loan balance (your last payment)

$2.229 X 40 = $89.16 This is how much interest you owe.

So, out of a $400 payment, $89.16 is will satisfy the interest that is due, with $310.84 going to the outstanding balance.

You can see from this exercise that by making extra payments towards the outstanding balance, you will pay less in interest charges.

Credit card companies will be changing the way that they calculate interest on your outstanding plastic card balances. Read this article at Kiplinger's for more about this.

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