Getting a loan to mend your financial situation can be tough on its own. Whatever your reason may be, it must be serious enough to be willing to get yourself into debt. The last thing you want at the moment is to get your life any more complicated, but one look at the word “interest” is enough to do the job.
However, understanding what interest is and how it’s calculated is an essential step in getting a loan. It makes all the difference in the choice you’re going to make, as it directly affects the total amount you’ll be paying. It also changes the structure of your debt, which can hugely affect your life if you’re not well-prepared.
Here’s everything you need to know to understand how a loan interest is calculated.
What Is Interest?
We’ll start by explaining what interest is in the first place. We’re all familiar with the idea of a loan. A lender gives you a certain amount of money, requiring you to make regular payments to pay off your debt. As heroic as that sounds, lending money is usually done to earn more. This is how lenders benefit from giving away their own money. To make a profit, the lender will add an interest rate in addition to the amount of money you’re borrowing. For instance, if you’re borrowing $100 and they demand the interest rate of 7%, then the total amount of money you’ll pay back is $107. You’ll be repaying the money on installments, depending on the schedule you agree upon. The first few installments you make will go into paying for the interest, and once the interest is paid in full, the remaining installments start to add up to pay for the amount you originally borrowed. This is the simplest idea behind an interest, but it can get much more complicated.
Factors Affecting the Interest Rate
Anyone pondering the idea of getting a loan should first look at the interest. One of the most important factors is your credit score; if you have a bad credit score, then lenders will increase the interest to secure their money. There are other factors that come into play, such as the amount of money you’re borrowing and the quantity and frequency of the installments you’ll pay.
Here’s how these factors will affect the interest rate of your loan:
Your credit score makes a significant difference for lenders when they consider lending you money, but they’ll also look at your debt and repayment history. If you have bad credit, they’ll either increase the rate or reject your application altogether.
2. Principal Amount
The amount you borrow is known as the principal amount. The bigger the amount, the bigger the chances that the interest will be higher.
3. Frequency and Amount of Payment
If your repayment schedule is constructed in a way that you make more frequent payments or payments of bigger amounts, then interest rates will be lower. Interest rates will go up if you repay the debt in lesser amounts over a longer period.
Different Kinds of Interest
How much interest comes with the loan depends on the way it’s calculated. If you’re wondering about the most important question—what would be your interest rate?—then it all depends on your initial agreement with your lender. Interest can be calculated in the simplest way that we’ve explained, in which case it’s a fixed interest rate that doesn’t change in time. However, interest can also become variable with economic changes.
Different kinds of interest rates can be divided into 3 categories:
1. Fixed Interest Rate
As their name indicates, fixed interest rates don’t change over time. If your agreement was 7% of the principal amount, then you’ll pay 7% of the specified amount. This provides more certainty and is more cost-effective if the economy fluctuates negatively.
2. Variable Interest Rate
Variable interest rates change with the economic changes, all of which depend on the prime rate. Usually, the interest rate will be fixed for a specific period of time and then changed when this period ends. Aside from its uncertainty, huge fluctuations can demand greater payments, which can put you in a financial pinch.
3. Prime Interest Rate
Prime interest rate offers the lowest interest rates on loan, but it’s usually only reserved for individuals with an excellent credit score.
Before getting a loan, the wisest thing to do is understand how you’ll be paying it back. This makes understanding interest and how it’s calculated your most important task. You may not be able to change the interest after signing the agreement, so it’s necessary that you make sure the loan structure is suitable for your situation before committing to it.