How Repayments Are Worked Out: Loan Repayment Formula

Have you ever wondered how your loan repayments are worked out? To work out loan repayments, your loan amount is divided by your loan term (usually months) to get a monthly payment. Then, an interest that the bank calculates based on your unique circumstances is tacked on to your basic monthly payment. Your monthly repayment is your principal divided by repayment term in months plus monthly interest (APR divided by 12 x principal).

This explanation is grossly simplified. In this post, we’ll look at what influences your interest rate, and loan terms, and how to reduce your repayments.

How to Work Your Loan Repayments

First, let’s define some of the key terms we’ll use throughout the post.

• Principal: the basic loan amount before interest and fees are added
• Interest: the percentage of the principal you pay to the bank as a lending fee.
• Loan term/repayment period: how long you pay the loan for
• APR: annual percentage rate. The percentage of your loan you’ll pay annually.

To calculate a loan repayment, divide your principal plus interest by your loan term.

Example

Let’s look at an example. In this example, Mary wants to take out a R100 000 car finance and pay it off over 4 years. She has a good credit score and so secures the prime lending rate (11.5%). She does not put down a deposit. This example does not account for amortization.

Let’s use the formula M = P * r * (1 + r)^n / ((1 + r)^n – 1) where:

M = Monthly repayment
P = Loan amount
r = Monthly interest rate (APR divided by 100, then multiplied by 12– should be a decimal)
n = Number of monthly payments

Let’s make this formula more accessible.

The part following monthly repayment says P * r. We’ll call this value A. Let’s make value B 1 + r.

We’ll call this sum value C, which is equal to value A multiplied by value B raised to the power of our amount of monthly payments.

Next, we have to divide value C by 1 + our monthly interest rate raised to the power of our monthly payment number minus 1. This gives us M.

Let’s try it with Mary’s numbers.

P (loan amount) = 100 000
r = 0.0095833 because (11.5 / 100) / 12
n = 48

Let’s apply the formula.

Mary’s monthly repayments = 100 000 x 0.0095833 x (1 + 0.0095833) to the power of 48 divided by 1 + 0.0095833 to the power of 48 minus 1.

Mary pays R 2,608.90 per month.

What’s Amortization?

As you make payments toward your loan, you’ll reduce the amount left to pay on your principal. In turn, this reduces the interest you’ll be charged in the following months.

Working out amortization manually can be complex. To calculate your amortization schedule, multiply the previous month’s ending balance by the monthly interest rate, subtract the interest from your monthly payment, and then subtract your principal payment from the previous month’s ending payment.

To get an accurate amortization schedule, use an online tool or ask your lender.

What Influences the Interest Charged?

The interest you’ll pay in addition to your principal varies by your credit score, the prime lending rate and repo rate changes, and your payment history.

When the repo rate (interest rate the central bank lends money to commercial banks at) goes up or down, your monthly interest rate payments will fluctuate, if only incrementally. For example, September’s 25-point interest drop meant that most homeowners now save a few hundred rand per month.

Your credit score and payment history also influence the interest you’re charged. Having derogatory marks or a history of late payments on your credit profile usually means that the interest you’ll pay will be higher than if you have a history of on-time payments and a low credit utilisation rate (How much credit you use compared to your limit).

What if I’m Paying Too Much on My Loans?

If you can’t afford your loan repayments, consider debt review. This is a legal process where a debt counsellor negotiates on your behalf for lower repayments, lower interest, legal protection and asset protection on your behalf.

We’ll help you become debt-free while enjoying legal protection and savings on debt. Become debt-free–contact Debtco Group today.