How To Calculate Interest on Debt? Step by Step Guide
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During college, students usually skip all the mathematics questions with interest calculations in them.
If you’re having similar trouble like calculating interest on your credit card, keep on reading.
I’ve compiled a comprehensive guide with an example on how to work out interest on a debt.
Let’s dive right in!
What is Interest?
Every asset has a value, and since money is also an asset, you have to pay a price to acquire it.
In some cases, this price is a service, while in others, the price is a product. But what happens when you’re straight up borrowing money from someone else?
Let’s answer that question:
The price of money is… Additional money! If you borrow money from someone, the price you pay for it is an annual percentage of the total amount borrowed. This amount is paid in addition to the invoice value of the loan and is called interest.
Moreover, this amount is to be paid up until a due date which is already decided. On the due date, you are supposed to repay the loan, along with the additional fees pertaining to the loan.
But here’s the thing:
The amount you’re supposed to pay additionally is usually predetermined contractually. In case you are borrowing from a bank, you will have to follow the interest rate set by the Monetary Policy Committee.
There are two types of interests:
When you borrow money from an entity, they tell you the price for it beforehand. This predetermined price, which is to be paid every year until the due date, is usually written down and signed upon by both parties and is called contractual interest.
Usually it is advised that while giving or receiving a loan, keep everything in writing. Avoid verbal agreements. Agreements over an electronic source like over your email address are also fine.
If you are by any chance late in repaying your dues, there’s a price for that too. This price is called the statutory interest and is basically daily interest paid according to each day that your repayment of the loan is delayed.
Statutory interest is applied so that businesses avoid late payment and defaulting on loans. The exact rate is 8% plus the base rate set by the Bank of England for business to business transactions.
When Does a Payment Become Late?
When you borrow money, your lender decides a due date by which it is to be returned. If you miss this due date by even one day, you must pay an additional fee for being late.
This fee can be in the form of daily interest, which charges you according to the number of days passed since the due date. Other than that, there can be a fixed late fee for the delay in payment. The exact details vary from contract to contract.
However, late payments don’t get reported to credit bureaus until they are at least 30 days late. This means that a late payment will only appear on your credit report if you miss the due date by 30 days. This mistake will then stay on your credit report for 7 whole years.
How to Calculate Interest?
Interest is expressed in percentages and it is applied annually on your debt. The calculations are fairly simple but there are some different applicable scenarios.
If you’re wondering:
“What if I want to pay the interest on a monthly basis? Do I still have to pay the same amount?”
The answer to that question will be no. If you want to make monthly payments, you will simply divide your annual rate of interest by 12.
Finally, let’s cut to the chase:
Interest is calculated by the following formula:
A = P( 1 + rt )
This formula might seem perplexing but it is very simple.
- A means the amount to be paid.
- P is the principal amount that you borrowed from the lender.
- r is the interest rate divided by 100
- t is the number of time periods that have elapsed.
For example, if the additional amount to be paid is 5% annually on a debt of a 100 pounds, at the end of two years, you will have to pay an additional amount of 0.05*100*2 = 10 pounds. This is the price you pay for borrowing a 100 pounds for two years.
Debt Recovery Costs
If you default on your debt, the lender will most probably contact relevant authorities who will review the contract and take you to court over it. This only means additional problems for you.
Here’s a question you may have:
“Will the lender really spend more cash in court to recover the debt?”
The answer is yes and if he wins the case, he can demand that you pay the debt recovery costs, this means that in addition to the loan, you will have to pay a fee for late payment along with the costs incurred by the lender to recover his debt from you.
The bottom line is:
Don’t default on debts.
To avoid unnecessary disputes, you should have a grip on basic things like daily interest, base rate and interest payments.
If you understand these, calculating interest will be a walk in the park.
I hope this guide was simple and easy to understand, if I missed something, feel free to reach out!