how does interest work on a loan

According to the Financial Industry Regulatory Authority, only about one-third of Americans have a working understanding of interest rates.1 So, how do you explain interest rates? 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: 

Type of InterestDescription
Simple InterestInterest is calculated only on the initial principal amount over a specified time period. It does not consider any interest that may accrue on previously earned interest. 
Compound InterestThe interest you pay is calculated on both the initial principal and any accumulated interest from previous periods. It allows for exponential growth of the invested or borrowed amount over time. 
Fixed InterestA type of interest rate that remains constant throughout the life of a financial instrument (e.g., a loan or bond). Borrowers and investors can expect consistent interest payments or returns.
Variable InterestAn interest rate that can change over time based on market conditions or a specific index. Borrowers or investors may experience fluctuations in interest or returns, making it less predictable compared to fixed interest rates.

How Do Lenders Determine the Interest Rate on a Loan?

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

  • A Loan’s Principal Balance— The higher the principal, 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 and apply for appropriate financial products. 
  • Research lenders and loan types before committing and signing a contract.  

Work on Your Credit 

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. 

Compounding Interest

If a loan has this kind of 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 this interest type.

Fixed Interest / Fixed Rate Loans 

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 looking to keep their finances organized while they repay 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 in 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 loan options 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 Mortgage Interest Works

How does mortgage interest work? Over the past four decades, mortgage interest has varied between 3.56% and 16.64%.2 Most of the time, mortgage interest will be simple interest. 

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 loans and mortgage lenders and compare information like: 

  • Interest offered. 
  • Closing costs/fees. 
  • Extra administration fees. 
  • Any brokerage fees.
  • Mortgage payments.
  • The loan limit (some mortgage loan options offer more than the conforming loan limit)

Paying Interest on Credit Cards 

The average interest rate on credit cards is approximately 14-24%.2 Unlike payday loans, 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 Auto Loans

A car loan/auto loan typically has an interest rate between 4-5%.2 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 an auto loan, the lender has the right to repossess your vehicle should you default. 

Ways To Save Money on Interest While Paying Back a Loan

Everybody wants to save funds 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. That means borrowers may pay less interest on short-term loans. 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. 

Refinance

Another way to potentially save money and get a lower interest rate 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.   

FAQS

What is the difference between APR and interest rate?

While the interest rate simply represents the cost of borrowing the principal amount, the APR (annual percentage rate) includes the interest rate along with other fees and costs associated with the loan. It provides a more comprehensive view of the true cost of borrowing.

Is it possible for interest rates to be negative?

While rare, some countries have experienced negative interest rates, primarily on deposits. This essentially means that instead of earning interest on deposits, depositors might pay the bank to keep their money, for example, in a savings account. However, in the context of loans, it would mean borrowers would pay back less than they borrowed. Investments such as savings accounts or CDs earn interest. 

How does one’s employment status affect the interest rate on a loan?

Employment status can influence perceived risk by the lender. Typically, those with stable employment might receive a more favorable interest rate, as they are deemed more likely to repay the loan consistently.

Why do credit cards often have a higher interest rate than other types of loans?

Credit cards are unsecured loans, meaning they aren’t backed by collateral. This increased risk, combined with the revolving nature of credit card debt, typically results in a higher interest rate.

Can I negotiate the interest rate with my lender?

In some cases, yes. It often depends on the lender, the type of loan, and your financial profile. It’s always worth asking or negotiating, especially if you have a good credit score or a longstanding relationship with the lender.

How do federal interest rate decisions impact a personal loan’s interest rate?

Federal or central bank decisions on interest rates can influence the broader financial market. When the central bank raises or lowers interest rates, it often leads to corresponding changes in interest rates for various credit products, including personal loans.

How do fixed-rate loans and variable loans impact interest with a mortgage loan or personal loan?

A fixed-rate loan means the interest rate remains constant throughout the duration of the loan. So, your monthly payment remains consistent, allowing for easier budgeting. Conversely, variable interest rates fluctuate based on market conditions, so the interest you pay might increase or decrease over time. If market rates rise significantly, this could lead to higher interest compared to a fixed-rate loan.

For those borrowing money, especially with auto loans and personal loans, how can one save on monthly payments and overall interest costs?
Your credit score plays a pivotal role in determining interest rates. Borrowers with higher scores are seen as less risky, so they often qualify for more favorable interest rates. 

By maintaining a good credit score, borrowers can save both in terms of lower monthly payments and reduced overall interest. Regularly checking your credit report, ensuring timely payments, and reducing your loan’s principal balance faster can improve your credit score over time.

CreditNinja’s Thoughts on Interest Rates

Understanding interest and how it works can make a significant difference in the financial decisions you make, from selecting the right loan to optimizing your savings accounts. At CreditNinja, we’re committed to empowering our customers with the knowledge and tools to navigate the financial landscape confidently. Whether you’re considering personal loans, managing monthly payments, or optimizing your savings accounts for better returns, trust CreditNinja to guide you every step of the way.

References:

  1. National Study by FINRA Foundation Finds U.S. Adults’ Financial Capability Has Generally Grown Despite Pandemic Disruption | FINRA
  2. What are Interest Rates & How Does Interest Work? | Credit.org
  3. What Is Interest and How Does It Work? | Experian

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