How does interest work on a loan

By Sarah R
Modified on June 7, 2023
how does interest work on a loan

How does interest work on a loan? Interest rates depend on factors like where you live, what financial product you choose, and your overall financial situation. Here, you will learn all about interest rates, how they are calculated, and how you can save the most money possible when you borrow money! 

What Are Interest Rates?

Interest rates are essentially the price consumers pay when borrowing money. In order to make a profit, lenders and financial institutions charge interest when they lend money. Some common types of interest you may come across are: 

  • Simple interest. 
  • Compound interest. 
  • Fixed interest. 
  • Variable interest. 

How Do Lenders Determine the Interest Rate on a Loan?

Interest rates are determined by a variety of factors. They are: 

  • Principal Loan Amount — The higher the loan amount, the more borrowers will pay in interest. 
  • Loan Term — The longer the loan term, the more borrowers will pay in interest. 
  • Repayment Schedule — Borrowers who have their payments spaced out will pay less in monthly installments but will pay more in interest over the life of their loan. 
  • Market Conditions — For many loans, rates are partially determined by current market conditions. When the market is doing well, rates are lower, and vice versa. 
  • Creditworthiness — Lenders will usually pair lower rates to borrowers with credit scores on the higher side. 

How To Get the Best Interest Rate When You Need To Borrow Money?

Looking for the best interest rates on your loan? Before applying for any type of funding, you should: 

  • Look at your credit score and apply for appropriate financial products. 
  • Research lenders and loan types before committing and signing a contract.  

Work on Your Credit Score

One of the best ways to get paired with low-interest rates on a loan is to have an ideal credit history. If you have less than perfect credit, you may want to try: 

  • Making payments for bills and loans on time. 
  • Prioritizing and paying off debts. 
  • Avoiding loan default or delinquency. 
  • Use your credit cards wisely and try not to carry a balance. 

Research Lenders and Loan Types

It is also important to do your own research on lenders and loan types before you commit to any kind of financial product. If you go with the first lender or loan type you come across; chances are you will find out you could have received a better deal somewhere else! 

What Are the Different Ways To Pay Interest? 

If you want to calculate interest costs for your loan, the first thing to determine is what kind of rates your loan has. Below is more information on the different types of interest rates you may find on funding. 

What Is an APR?

The annual percentage rate of a loan also referred to as the APR, is how much interest a borrower will pay over the span of one year. 

Simple Interest

If a loan has simple interest, it means that the rates are calculated using only the principal balance. Most loan types use simple interest when determining rates for borrowers. Simple interest may be charged at either fixed or variable rates. 

Compound Interest

If a loan has compound interest, it means the rates are calculated using:

  • The principal loan amount. 
  • Interest rate charges from past payments. 

Many people refer to compound interest as “interest on interest.” This name refers to the fact that past interest charges are used to calculate the new amount of interest charged on each monthly payment. 

Federal student loans are an example of a form of funding that commonly uses compound interest.

Fixed Interest

If a loan has fixed interest, that means the rate does not change throughout the life of the loan. Many borrowers prefer loans with fixed interest rates because it means that each of their monthly payments should be roughly the same. Fixed interest loans are often the optimal choice for borrowers who are looking to keep their finances organized while they pay back their loans. 

Variable Interest

As the opposite of a fixed rate loan, variable interest on a loan means the rate may change throughout the life of the loan. For this type of loan, interest rates are determined by the current conditions of the market. That means when the market is good; borrowers may save on interest, but they may pay more other months if the market isn’t doing so well.

Paying Interest on Personal Loans 

Interest rates on personal installment loans are known for being competitive. It’s common for borrowers with both high and low credit scores to turn to personal loans when they need quick and efficient funding. 

Like most loans, interest charges for a personal loan are broken up into each monthly installment. That means part of each installment will go towards paying off the principal balance, and the other part will go towards interest charges. 

Paying Interest on Mortgage Loans

How does mortgage interest work? Over the past four decades, mortgage rates have varied between 3.56% and 16.64%. A mortgage loan will most likely use simple interest, so you will only have to pay for the principal amount. The APR of a mortgage loan is applied to the principal balance and then divided up and included as part of each monthly payment. 

When looking to purchase your own home, make sure you research mortgage lenders and compare information like: 

  • Interest rates offered. 
  • Closing costs/fees. 
  • Extra administration fees. 
  • Any brokerage fees.

Paying Interest on Credit Cards 

The average interest rate on credit cards is approximately 14-24%. Unlike payday loans online same day, personal loans, and traditional installment loans, credit cards only charge interest on the funds used. That means if you have a Credit limit of $1,000 but only spend $100 within a given billing cycle, you will only be charged interest on the $100 spent, not the entire $1,000 limit. 

Paying Interest on a Car Loan/Auto Loan

A car loan/auto loan typically has an interest rate between 4-5%. Since cars are so expensive and used as collateral for auto loans, lenders can usually charge interest rates on the lower side. However, since the vehicle is used as collateral for a car loan, the lender has the right to repossess your vehicle should you default. 

Ways To Save Money on Interest Rates While Paying Back a Loan

Everybody wants to save money when it comes to interest rates. Fortunately, there are things you can do on your end to shave down the cost of interest. 

Pay a Bit Extra Each Month

If possible, pay more than your minimum monthly payment each month. By making larger payments or even more frequent payments, you can pay off your loan months or potentially years before your scheduled payoff date. 

Opt For Shorter Loan-terms

Your loan term plays a major role in how much interest you will pay. The longer the loan term, the more money you will pay in interest. To determine the best loan terms for you, think about the maximum amount you would be able to pay towards your loan each month. Then, pick loan terms that match up with that maximum amount. It may be a good idea to go with terms that result in a payment slightly lower than your maximum amount, so you aren’t completely thrown off if something in your budget changes. 


Another way to potentially save money and get lower interest rates is to refinance your loan. When you refinance, you are paired with an entirely new loan deal that comes with fresh rates, terms, and sometimes even additional funding. If you have had a major boost in your credit score since initially applying for your loan, you may see a significant improvement in rates and terms.

Ways To Get Extra Cash To Pay Your Loan

Sometimes the best way to save on interest rates is to knock out your loan balance as quickly as possible. Take advantage of the tips below to pay off your loan faster and save on interest rates at the same time! 

Dip Into Your Savings Account 

If you have an emergency fund or a savings account, you may consider using part of those funds to help pay off your loan. While you don’t want to completely empty your savings in order to pay off your loan balance, taking a small portion to make a few extra payments can potentially save you hundreds of dollars in the long run. 

Get Some Temporary Part-time Income

If you feel you can work a second job and not burn out, you may want to get an additional stream of income while you pay back your loan. There are even jobs you can do from home so you can earn extra cash from the comfort of your own living room! Some common remote jobs you may consider for some extra money are: 

  • Freelance writing. 
  • Virtual assistant. 
  • Dog sitting/babysitting/house sitting. 
  • Virtual freelance work.   

What Is Interest and How Does It Work? – Experian
What are Interest Rates & How Does Interest Work? |

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