How to calculate the real cost of a loan in your head!

I’m in the middle of filming a Tonight with Trevor on Payment Protection Insurance for loans. Historically many have got this insurance without realising it, because they’ve no idea how much a loan should actually cost, and it adds thousands to loan costs (see cheapest loans article). It’s not surprising really as it is hugely difficult to work out, even with a calculator, hence when I’m doing it (especially if it’s live on telly) I have an easy method to make a rough estimate. It occurred to me some people may find it useful, so here you go.

How to do it

Take the example of a £10,000 loan over 5 years at 8% APR interest (see how interest rates work article for an explanation of APRs).

Step 1. Estimate the average debt over the life of the loan.

Remember you only pay interest on the outstanding debt, and with a loan you make fixed monthly repayments, so over the five years the amount of interest you’re paying decreases. Therefore I always simply halve the total debt and consider this to be the rough average debt over the life of the loan. E.g. half £10,000 is £5,000

Step 2. Work out the annual interest on the average debt.

Now work out one year’s interest on that debt. E.g. 8% of £5,000 is £400

Step 3. Work out the total interest on the average debt.

Simply multiply the average interest by the number of years. E.g. £400 x 5 years = £2,000 interest

Step 4. Factor in compound interest.

It all works well up to here, the simple interest is roughly £2,000. Yet the rough average debt figure from earlier is of course too low, because the interest cost compounds (read an explanation of compound interest) meaning we haven’t factored in paying interest on the interest. Therefore to make it more accurate, we need to guesstimate a bit on top for compound interest – the longer the loan and the higher the interest rate the more you should add.

In this case I’m going to guess about £200 worth of extra interest – bringing the sum to £2,200 (if you want to get good, go to a web loan calculator (e.g. the Guardians) and practice with a few examples to get the estimates working).

In actual fact the real interest, is £2,165 – so that’s pretty close. I hope this is useful (if you’ve any other quick money calculation tips, please add them to the discussion link below).

Still Not Sure? Watch a mini video I’ve done explaining this {how to do loan interest video}

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