Educational Article • 5 min read
How Loan Interest Works
When you borrow money, you agree to repay the original amount (principal) plus an extra fee charged by the lender for the service. This fee is **interest**.
How Lenders Compute Monthly Interest
Most amortization loans (like home, car, and personal loans) compute interest using **simple interest calculated on a reducing balance monthly**.
Each month, the interest charge is computed by multiplying the outstanding balance by your monthly interest rate:
Monthly Interest = Remaining Balance × (Annual Rate / 12)
For example, if you have an outstanding balance of **$200,000** and an annual interest rate of **6%**:
- Monthly Rate = 6% / 12 = 0.5% (or 0.005)
- Interest Charged for that month = $200,000 × 0.005 = $1,000
Interest Rate vs. APR (Annual Percentage Rate)
Lenders often advertise two numbers: the Interest Rate and the APR.
- Interest Rate: The cost to borrow the principal balance annually. It does not include fees or closing charges.
- APR: The comprehensive cost of borrowing, which bundles the interest rate plus any lender fees, origination charges, or points. APR represents the real annual cost of the loan and is the number you should use when comparing lenders.
Visualize Interest Charges
Use our standard loan calculator to visualize exactly what portion of your monthly payment goes toward interest versus principal.
Calculate Interest Now →