Credit transactions have come to be the lifeblood of commerce. Wherever credit is extended, someone has incurred debt, and the management of this debt has become an issue for millions of consumers. Without good debt management, credit balances can easily spiral out of control. One of the keys to managing one's debt is to understand the manner in which interest is calculated and added to the balance.
For fully amortized loans, such as mortgages and auto loans, the calculation is done once at the beginning of the loan and the monthly payment is calculated so as to include the interest. As long as the payment is made on time, there is no necessity to recalculate the accrued interest. However, understanding the interest calculation is helpful in comprehending how each monthly payment is applied.
For a fixed-rate loan, the interest is determined by the interest rate. The interest rate tells what percentage of the outstanding balance, is to be added to the balance every year. The interest is the primary source of income for the lender.
For example, on a $100000 loan at 8%, roughly $8000 ($100000 X 8%) will be added to the balance in the first year as interest. In reality, it will be something less than $8000, because the balance will diminish with each payment made.
For fully amortized loans, the interest accrues daily. That is, the 8% per year is divided by 365, and that amount of interest is added to the balance every day. For our $100000 example, 8% divided by 365 equals 0.0002191%. 0.0002191% of $100000, or $21.91, will be added to the balance every day until a payment is made. At the end of 30 days, $21.91 X 30 = 657.30 will have been added to the balance.
On the 31st day, if the mortgage payment is applied (the payment on a 30-yr loan of $100000 at an interest rate of 8% is $666.67), the balance is reduced to $99990.63 ($100000 + $657.30 - $666.67). The cycle begins again with the 0.0002191% interest rate now applied to the $99990.63 balance.
As the balance decreases, the accrued interest becomes less every month, and more of the monthly payment is applied to the principal. This cycle continues every month for the life of the loan. Eventually, more of the payment is applied to principal than to interest. Because of this pattern, any additional payment of principal early on in the life of the loan has a significant impact, because the amount paid never accrues any more interest, allowing each future payment to pay down the balance a little bit more.
Credit card interest is applied differently. Most credit cards calculate interest on the "average daily balance" and add the interest charge to the account once per month. The average daily balance is simply the average balance on the account over the course of the monthly billing period. For example, if the billing period opens with a $1000 account balance, and the balance is paid off on the 15th day, the average daily balance for the period is $500. The daily interest rate (nominal interest rate divided by 365) is applied to the average daily balance times the number of days in the billing period.
In the example cited above, if the average daily balance is $500, and the interest rate is 8%, the interest accrued in the billing period that includes the end of February would be 0.0002191% X $500 X 28 days = $3.07.
Because credit card interest is calculated and assessed every month, the amount of interest charged will fluctuate up or down with the balance on the account. The minimum payment, which is also based on some combination of the accrued interest and interest rate will also fluctuate.
A simple way to estimate the interest rate is to apply it monthly rather than daily. The nominal interest rate divided by 12 will give the monthly interest rate. This can be applied to the approximate average balance to give a good estimate of the interest accrued during the period.
Applied to our credit card example, 8% divided by 12 is 2/3 of a percent. One percent of $500 is $5, and 2/3 of $5 is $3.33. By using this method and rounding the numbers, one can get a good approximation of the actual interest.
For more help with calculating interest rates, bankrate.com
has a range of calculators available for both mortgage and credit card loans.