How do I calculate interest on a loan?
September 25, 2013
Q: I borrowed $4,000 from a friend on March 1, 2013, and now I want to pay him back with interest. How much would he have earned on that amount in a checking account since then?
A: Not much! According to the FDIC, the average U.S. checking account is paying just 0.04 percent a year in interest. Back when you first borrowed the money, that rate was 0.05 percent. The checking account rate stayed there for about half the time since, so split the difference and call it 0.045 percent. At that rate of interest, a $4,000 balance would have earned just 97.5 cents from March 1, 2013 to Sept. 15, 2013.
In other words, if you just bought your friend lunch to thank him for the loan, you'd be more than making up for the lost interest. Even if the money had been in a saving or a money market account, he wouldn't have done much better. At the extreme, if he had shopped around and gotten one of the best rates available, which would be about 0.90 percent, he might have earned about $19 over that time.
Perhaps you might question whether that kind of deposit account interest rate is the appropriate interest rate to use for a loan like this. You logic may well be that the money came out of his checking account, so you are just making up for the interest he would have earned had he not loaned you the $4,000. However, when someone lends money, they are running the risk of not getting their money back, and they are relinquishing the use of that money over the time of the loan. Typically, a lender would be compensated for those things with something more than a checking account interest rate.
If you want to compensate your friend more like a professional lender would be compensated, you could use anything from the bank prime loan rate to a typical credit card rate. The bank prime loan rate is the rate banks charge their best, most credit-worthy customers. This rate is currently 3.25 percent. If your friend charged you that rate for the loan, it would have accrued just shy of $70.
That prime rate is normally reserved for institutional lending, so the credit card rate might be a more appropriate interest rate for you to use for an unsecured personal loan. The average credit card balance these days gets charged 12.76 percent a year. If your friend had charged you that rate from March 1 to September 15, then you would owe nearly $269 in interest. That's more than your friend would have earned in checking, but similar to what it would have cost you to borrow the money elsewhere.
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