How do you calculate the loan interest?

How do you calculate the loan interest?
Young man checking home finance

The calculation of loan interest is an important topic and is often misunderstood. In Switzerland, the effective interest rate is used to calculate a financing.

For a loan you pay a monthly interest, i.e. the loan bears monthly interest.

For example, if you take out a loan from 10,000 to 84 months at an interest rate of 9.9%, then you pay 9.9% interest for the amount of CHF 10,000 in the first month. In the second month you pay 9.9% loan interest on the remaining debt. This means the amount of 10000 minus the repayment part of the first monthly instalment.

This process is repeated every month. All in all, you have to pay back the loan of 10,000 over 7 years. This means 14.3% of the borrowed amount per year and 1.2% of the borrowed amount is repaid per month. In addition to this 1.2%, 9.9% interest is paid monthly on the outstanding balance.

Put simply, in the first month you pay 9.9% interest for 100% of the amount borrowed. In the second month, 9.9% interest is paid on the 98.8% of the amount borrowed. In the third month, 9.9% interest is paid on the 97.6% of the amount borrowed. This calculation goes on for another 81 months, then you have reached the 7-year term. Each month 1.2% is deducted from the balance, interest is paid on the remaining debt. At the end of this calculation you get the total amount you pay. This total amount is divided by the number of months for which the loan was taken out. In our example, this would be the total amount you have to pay by 84. So we get the monthly installment. In order to calculate all this more easily, we use the annuity.
The Annuity

In financial mathematics, an annuity is a regular annual payment consisting of the elements interest and repayment (amount owed). The amount of the monthly installment does not change during the entire term. A constant rate is called annuity. A rate consists of two parts. From the interest portion and from the repayment portion.Although the monthly rate remains the same for the entire term, the ratio of interest portion and repayment portion changes.

At the beginning of an annuity payment, the interest portion is very high as a percentage of the repayment portion, since the loan amount still exists in full. However, due to the regular repayment instalments, the amount of residual debt a borrower has with a lender decreases. As a result, the interest portion decreases with each payment, since the amount also decreases. At the same time, the repayment portion increases so that the total amount remains constant and the borrower pays off the loan more quickly with each payment.

Various types of capital payment

There are not only loan rates calculated using the annuity method, but mortgage rates are also calculated using this method. In contrast to loan interest, where the interest rate is adjusted to the monthly residual debt, the mortgage amount only bears interest annually and not monthly. This means that if you take out a mortgage for 20 years, you pay, for example, 3% for 100% of the mortgage amount in the first year. In the second year, 3% interest is paid on, for example, 94% of the mortgage amount.

Various types of repayment/repayment

There are not only the annuity loans, but also the amortizable loans and the loans due at maturity. With the amortizable loan, the interest portion of the installment always becomes smaller and the amortizable portion always remains the same. When the loan matures at the end of the term, there is only one interest payment.

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