How to Calculate Loan Interest (Simple vs. Compound)
Interest is the price of borrowing money — but it's not calculated the same way on every loan. There are two main methods: simple interest and compound interest. Knowing which one your loan uses tells you what you'll actually pay.
Here's how to calculate both.
Simple Interest: The Easy Formula
Simple interest is charged only on the original amount you borrowed. The formula is:
Interest = Principal × Rate × Time
- Principal = the amount borrowed
- Rate = annual interest rate (as a decimal)
- Time = number of years
Example: $10,000 at 8% for 3 Years
Interest = $10,000 × 0.08 × 3 = $2,400
Total you'd pay back = $10,000 + $2,400 = $12,400
Simple interest is common on car loans, short-term personal loans, and some mortgages (when calculated on a daily basis).
💡 Skip the math: The RateLedger loan calculator calculates your payment and total interest instantly — no formula needed.
Compound Interest: Interest on Interest
Compound interest is calculated on your balance plus the interest already added. It grows faster, because you pay (or earn) interest on interest. The formula:
A = P × (1 + r/n)^(n × t)
- A = final amount
- P = principal
- r = annual rate (as a decimal)
- n = compounding periods per year
- t = years
Compound interest is why credit card debt spirals so quickly — and why savings accounts grow. The same math works both ways.
Simple vs. Compound: The Same Loan, Different Cost
Compare $10,000 at 8% over 3 years:
| Method | Total interest | Total repaid |
|---|---|---|
| Simple interest | $2,400 | $12,400 |
| Compound (monthly) | $2,702 | $12,702 |
The difference ($303) looks small over 3 years — but stretch it to 20 or 30 years and the gap becomes enormous. This is exactly why mortgages (which effectively compound over decades) cost so much in total interest.
How Lenders Calculate Your Monthly Payment
Most installment loans (mortgages, auto loans, personal loans) use the amortization formula, which combines the loan amount, rate, and term into a fixed monthly payment:
M = P × [ r(1 + r)ⁿ ] ÷ [ (1 + r)ⁿ − 1 ]
- r = monthly rate (annual ÷ 12)
- n = total number of payments
Your monthly payment stays the same, but the split between interest and principal shifts over time — more interest early, more principal later.
3 Ways to Reduce the Interest You Pay
- Borrow less — a smaller principal means less interest, period.
- Shorten the term — a 5-year loan charges far less total interest than a 7-year loan at the same rate.
- Pay extra toward principal — every extra dollar lowers your balance, which lowers next month's interest.
Frequently Asked Questions
What's the formula for simple interest? Interest = Principal × Rate × Time. For example, $10,000 at 8% for 3 years = $2,400 in interest.
What's the difference between simple and compound interest? Simple interest is charged only on the original principal. Compound interest is charged on the principal plus accumulated interest, so it grows faster over time.
Do mortgages use simple or compound interest? Most mortgages use simple interest calculated monthly on the remaining balance — which effectively compounds over the life of the loan, since interest is added to the balance each period before the next calculation.
How can I lower my total loan interest? Borrow less, choose a shorter term, get a lower rate (better credit helps), and make extra principal payments whenever possible.
Know your exact cost before you borrow. Open the RateLedger loan calculator now.