How to calculate the interest rate on a personal loan

Calculating an interest rate on a personal loan is a complicated task, not only because the formula is really complex, but because the terms that are part of it are also difficult to understand in many cases.

how to calculate interest rate

Therefore, in this article we will try to explain the most important terms that have to do with the interest rate and in the final part we will approach a practical example that will make it better understood.

In a simplified way, it can be said that the interest rate is the price of money. Yes, money has a price, that’s why you can buy it. In fact, when you ask for a loan you are buying money that you do not have and that the client will pay the lender, either in installments over time or once in the future when the client has liquidity again.

The lenders charge interest because, obviously, they need to have a percentage of benefits to make their activity viable, like any other profession or sector. In the case of banks, in addition, the collection of interest has to do with the fact that they themselves also pay interest when they buy money in the interbank market: that is, that banks lend each other at a certain interest rate, the famous one. Euribor, as we will see.

Fixed interest rate Vs variable interest rate

The fixed interest rate is, as its name suggests, the one that does not change over time. If it is done based on an investment, the percentage of profitability will always be the same. In the case of loans, which is the subject that interests us here, it makes reference to the fact that the cost will always be proportionally the same with respect to the borrowed capital.

On the other hand, the variable interest rate does change, and it does so because the percentage that is set as a cost for the client is the Euribor plus a spread. That is to say, the banks want to make sure that the benefits that they would obtain by granting a loan would never be inferior to their own expenses, that is to say, what the Euribor indicates. Therefore they establish a differential, which is usually expressed as Euribor + x%. For example, Euribor + 10%, although in some cases the differential can be applied to other reference indices.

The fixed interest rates tend to be more expensive for the client (more commissions are paid), while the variables used to be more economic, although this trend is becoming more nuanced. In fact, it should be borne in mind that the Euribor is a very variable index that can rise quickly and give us an upset in the form of very large commissions. On other occasions, even if the Euribor is low, if the spread is very high, the set of variable interest to be paid will also be high.

In this sense, and as a parenthesis, it is interesting to know that the interests paid in an online microcredit are usually quite contained. Therefore, the fees charged by Babar are always clear and without surprises, indicated before making the request for the personal loan online .

Simple interest rate and compound interest rate

Another distinction that needs to be clear is that of the simple interest rate and the compound interest rate. In the simple, the interests that are generated are only in relation to the initial capital loaned. That is, if the bank lends you 1,000 euros s return in two years at a simple nominal interest (now we will explain the ‘nominal’) of 10%, you will pay 100 euros in interest each year, 200 euros in total.

On the other hand, compound interest, to calculate the amount to be paid, adds the interest that is generated over time. That is, if the bank lends you 1,000 euros at a compound interest rate of 10% per annum to be repaid in two years, the interest would be 100 euros the first year and 110 euros the second, because the capital of the second year was 1,100 euros (1,000 euros plus interest 100). Therefore, a total of 210 euros will have been paid as interest at the time of loan repayment.

Nominal interest rate Vs TAE

Finally, a very important distinction: the nominal interest and the APR. The nominal interest rate (TIN) is the interest that the lender charges with respect to the loaned capital. However, the APR (Annual Equivalent Rate), also expressed in percentage, is the true cost of a credit for a client, since it includes the associated expenses, such as study fees, opening fees, etc.

Therefore, when we talk about calculating the interest rate, we should specify more, calculating in reality the APR, which are the actual expenses that we will pay for a loan, expressed year after year, that is why it is called ‘annual’.

The calculation formula is: TAE = (1 + (i / k)) k-1, where i is the nominal interest rate and k the number of periods established to settle interest. As it is a really complex equation, we recommend using simple online tools, such as the Bank of Spain Simulator .

Finally, following the examples handled so far, in a loan of 1,000 euros, with 30 euros of commissions, 30 euros of insurance premiums, with a nominal interest of 10% and with a repayment term of 2 years, the resulting APR It will be 17.53% of commissions each year.