How to Calculate Interest Saved by Making Extra Payments
Making extra payments on your loans can be a smart financial move, as it helps you reduce the total interest paid over the life of the loan. However, many people are unsure of how to calculate the interest saved by making these additional payments. In this article, we will guide you through the process of calculating the interest saved on your loans when you make extra payments.
Understanding the Formula
To calculate the interest saved by making extra payments, you need to understand the formula for calculating the total interest paid on a loan. The formula is as follows:
Total Interest Paid = (Loan Amount (1 + Interest Rate)^Number of Payments) / (1 + Interest Rate)^Number of Payments – 1
In this formula, the “Loan Amount” is the initial amount you borrowed, the “Interest Rate” is the annual interest rate expressed as a decimal, and the “Number of Payments” is the total number of payments you will make on the loan.
Calculating Interest Saved
To calculate the interest saved by making extra payments, you need to compare the total interest paid with and without the extra payments. Here’s how you can do it:
1. Calculate the total interest paid without extra payments using the formula mentioned above.
2. Determine the new number of payments you will make with the extra payments. This can be done by dividing the remaining balance by the monthly payment amount.
3. Calculate the total interest paid with the extra payments using the formula, but adjust the “Number of Payments” to the new number of payments.
4. Subtract the total interest paid with extra payments from the total interest paid without extra payments to find the interest saved.
Example
Let’s say you have a $10,000 loan with an annual interest rate of 5% and a term of 5 years. Your monthly payment is $200. You decide to make an extra payment of $100 each month.
1. Calculate the total interest paid without extra payments: Total Interest Paid = (10,000 (1 + 0.05)^60) / (1 + 0.05)^60 – 1 = $3,798.24
2. Determine the new number of payments: Remaining balance = 10,000 – (200 5) = $7,000; New Number of Payments = 7,000 / 200 = 35
3. Calculate the total interest paid with extra payments: Total Interest Paid = (7,000 (1 + 0.05)^35) / (1 + 0.05)^35 – 1 = $2,798.24
4. Subtract the total interest paid with extra payments from the total interest paid without extra payments: Interest Saved = $3,798.24 – $2,798.24 = $1,000
In this example, making extra payments of $100 each month will save you $1,000 in interest over the life of the loan.
Conclusion
Calculating the interest saved by making extra payments is a straightforward process once you understand the formula. By making extra payments, you can reduce the total interest paid on your loans, saving you money in the long run. Keep in mind that the actual interest saved may vary depending on the loan type, interest rate, and the amount of extra payments you make.
