Personal Loan Interest Rates: How a Personal Loan Is Calculated

What Are Interest Rates on Personal Loan?

Personal loans are a type of closed-end credit, with set monthly payments over a predetermined period (e.g., three, four, or five years). Interest rates on personal loans are expressed as a percentage of the principal—the amount you borrow.

The rate quoted is the nominal annual percentage rate (APR) or the rate applied to your loan each year, including any fees and other costs, but not including costs related to compounding or the effect of inflation. Most personal loans actually use the monthly periodic rate, which is arrived at by dividing the APR by 12. When applied to the principal, the APR (or periodic rate) determines the additional amount you will pay to borrow the principal and pay it back over time.

Understanding Personal Loan Interest Rates

To make loans, banks have to first borrow the money themselves, either from other banks or from their customers’ deposits. The interest rate on a personal loan reflects how much it costs a bank to borrow money, in addition to the inherent risk of lending money when there is no guarantee that it will be repaid.

Three important factors determine the interest rate on a personal loan:

• The borrower’s creditworthiness: Borrowers with a high credit rating tend to get better rates because they have a lower risk of default.1 Lenders may also consider the borrower’s employment status and income, since these affect the likelihood of repayment. Borrowers with low income or a history of missed payments tend to get the highest interest rates because there is no certainty that they will be able to make full payments.
• The length of the loan: Lenders make more money from long-term loans than short-term ones because the debt has more time to accrue interest. As a result, they offer lower rates for longer-term loans. Some lenders may charge a prepayment penalty for borrowers who pay off their loans too quickly.
• The cost of borrowing: Banks borrow money from one another, at an interest rate that is based on the federal funds rate. This cost is then passed on to the consumer—if the cost of borrowing money is high, then interest rates for personal loans will be even higher.

A fourth factor is whether the borrower can secure the loan with collateral assets. This is discussed further below.

Unsecured vs. Secured Loans

Most personal loans are unsecured, meaning that the loan is not backed up by an asset that the lender can take. An example of an unsecured loan could be money you borrow to go on vacation. Unsecured loans typically come with a higher interest rate to reflect the additional risk that the lender takes.2

Loans can also be secured—that is, backed up by something of value. The thing you offer to assure the lender you will repay the loan is known as collateral. A home equity loan is an example of a secured loan because your home serves as collateral to guarantee repayment of the loan. Secured loans usually have a lower interest rate because the lender takes less risk.

A personal loan calculator is useful for determining how much a high-interest unsecured loan will cost you in interest compared to a low-interest secured one.

Regulation Z

In 1968, the Federal Reserve Board (FRB) implemented Regulation Z, which, in turn, created the Truth in Lending Act (TILA), designed to protect consumers when making financial transactions. Personal loans are part of that protection.

Subpart C—Section 1026.18 of Regulation Z requires lenders to disclose the APR, finance charge, amount financed, and the total of payments when it comes to closed-end personal loans. Other required disclosures include the number of payments, monthly payment amount, late fees, and whether there is a penalty for paying the loan off early.3

Average Interest Rate on a Personal Loan

The average APR on a 24-month unsecured personal loan in the United States was 12.17% in August 2023. The rate you pay, depending on the lender and your credit score, can range from 5.99% to 35.99%. For comparison, the average APR on a 60-month secured new car loan was 7.88% as of August 2023.4 This shows the interest-lowering power of a secured loan over an unsecured loan.

Calculation of Personal Loan Interest

Armed with Regulation Z disclosure requirements and knowledge of how interest on closed-end personal loans is calculated, it’s possible to make an informed choice when it comes to borrowing money. Lenders use one of three methods—simple, compound, or add-on—to calculate interest on personal loans. Each of these methods relies on the stated APR provided in the disclosure document.

Simple Interest Method

The most common method used for personal loans is the simple interest method, also known as the U.S. Rule method. The primary feature of simple interest is that the interest rate is always applied to the principal only.

Using the example of a $10,000 loan at 10% APR over five years (60 months), simply plug the appropriate numbers into Investopedia’s loan calculator. In this case, the beginning principal balance is $10,000, the interest rate is 10%, and the original term is 60 months.

The calculator returns the monthly payment plus the total principal and interest over the life of the loan. You can also get a complete five-year amortization schedule telling you exactly how much principal and interest you will pay each month.

As the calculator shows, with simple interest and on-time payments, the amount of interest you pay goes down over time, and the amount of your payment applied to the principal goes up until the loan is paid off. If you make your payments early or make extra payments, you will pay less interest overall and may even pay off your loan early.

If you pay late or skip payments, the amount of your payment applied to interest goes up, resulting in less of each payment applied to the principal. Interest (and late fees) are kept separate (escrow). Accumulated principal, interest, or late fees will be due at the end of your loan. Test these assertions by adding to the payment amount, reducing, or deleting payments to see the impact each has on the total you pay.

Compound Interest Method

With the compound interest method, also known as the normal or actuarial method, if you make all your payments on time, the results are the same as with the simple interest method because interest never accumulates. The same circumstances apply to paying early or making extra payments. Both can result in a shorter loan term and less interest paid overall.

If you are late or miss payments with a compound interest loan, the accumulated interest is added to the principal. Future interest calculations result in “interest on interest.” In this scenario, you will end up with even more leftover interest and principal at the end of your loan term. You can test these scenarios with the same online calculator by plugging in the same numbers but selecting “Normal” as the amortization method. Common examples of the use of compound interest are credit cards, student loans, and mortgages.

Add-on Interest Method

The add-on interest method doesn’t require a calculator. That’s because the interest is calculated upfront, added to the principal, and the total is divided by the number of payments (months).

To arrive at the amount of interest you will pay using the $10,000 loan example above, multiply the beginning balance by the APR times the number of years to pay off the loan—i.e., $10,000 × 0.10 × 5 = $5,000. Principal and interest add up to $15,000. Divide the $15,000 by 60 (the length of the loan) and your monthly payments will be $250, consisting of $166.67 principal and $83.33 interest.

Whether you pay on time, early, or late, the total paid will be $15,000 (not including potential late fees). Payday loans, short-term advance loans, and money loaned to subprime borrowers are examples of loans with add-on interest.