Interest Rates

Interest Rates Explained – understanding the true cost of borrowing

An interest rate is the amount lenders charge for borrowing money. It’s typically expressed as a percentage of the principal on an annual basis.

Interest rates will affect the cost of borrowing based on:

  • The amount of interest
  • How the interest rate is applied to loan payments
  • The type of interest

If you’ve ever found yourself paying more for your loan after extending the loan term, this guide will explain why that happens based on how lenders apply interest rate charges to loan payments.

Why Interest Rates Vary for Different Borrowers

Lenders typically charge a lower interest rate to borrowers with high credit scores since those borrowers are considered lower risk. On the other hand, borrowers with low credit scores often receive high interest rates because they are considered high-risk borrowers.

Borrowers with “excellent” credit scores ranging from 720-850 can sometimes receive personal loan interest rates ranging from 10.3% to 12.5%; whereas, borrowers with “poor” credit scores ranging from 300-629 are more likely to receive personal loan interest rates ranging from 28.5% to 32.0%.

Lenders use high interest rates to decrease the risk of lending money to people with bad credit. The interest paid on such loans can make up for or reduce a lender’s losses if a borrower doesn’t fully repay a loan.

Several other factors, in addition to your credit score, can affect your interest rate, including:

  • Credit history
  • Annual income
  • Debt-to-income ratio
  • Policies of a particular lender

How Interest Rates Are Applied to Loan Payments

The particular method that a lender uses to apply interest rates to loan payments will influence the actual amount of interest you end up paying for your loan.

Two main types of loans are addressed here: amortized loans and non-amortizing or interest-only loans. 

How Interest Rates are Applied in Amortized Loan Payments

Amortized loans have scheduled periodic payments that are applied to both principal and interest. Although the payments are equal in amount, the amounts of principal and interest vary each month. Usually, the amount of interest owed decreases as the amount of principal paid increases from one month to the next.

Another key feature of amortized loans is that the monthly payment first pays off the interest and any fees for that period, and then the remainder of the monthly payment reduces the principal. That means the interest amount in the next monthly payment will be less, since it will be calculated on the reduced principal. Meanwhile, the amount from the monthly payment that goes towards reducing your principal will increase because the monthly payment stays consistent throughout the loan term.

This sample amortization table shows the amortization schedule for the first and last four months of a $25,000 five-year loan (60 months) charging 11% interest (with monthly payments).

MonthMonthly paymentInterestPrincipalOutstanding BalanceTotal Interest paid
1$543.56$229.17$314.39$24,685.61$229.17
2$543.56$226.28$317.28$24,368.33$455.45
3$543.56$223.38$320.18$24,048.15$678.83
4$543.56$220.44$323.12$23,725.03$899.27
57$543.56$19.48$524.08$1,601.24$7,584.19
58$543.56$14.68$528.88$1,072.35$7,598.87
59$543.56$9.83$533.73$538.62$7,608.70
60$543.56$4.94$538.62$0.00$7,613.63

As you can see from the table, a significant portion of your monthly payment goes towards paying interest in the beginning. That changes as you get closer to the end of your loan term, when most of your monthly payment goes toward reducing the principal on your loan.

In the end, the total interest comes to $7,613.63 for a $25,000 five-year amortized loan (60 months) charging 11% interest (with monthly payments).

The interest rate is also vital in calculating the monthly payment for amortized loans. The following formula is used in calculating the amount of each payment for simple interest, amortized loans:

p = (P x R x (1 + R)N) ÷ ((1 + R)N – 1) = (P x r/n x (1 + r/n)n x t) ÷ ((1 + r/n)n x t – 1)

p = monthly payment amount

r = annual interest rate

n = number of payments per year

R = r/n = periodic interest rate

t = number of years

P = original principal

N = n x t = total number of payments  

Here’s an example of the payment calculation:

Ben and Lucy borrowed $20,000 on a simple interest amortized loan that had a 12% annual interest rate with a loan term of 3 years. Here is the calculation of their monthly payment, as well as the sum of all payments, and total interest they will pay:

P = original principal = $20,000

r = annual interest rate = 12%

n = number of payments per year = 12

R = periodic interest rate = r/n = 12%/12 = 1% = .01

t = number of years = 3

N = total number of payments = n x t = 12 x 3 = 36

p = payment amount = (P x R x (1 + R)N) ÷ ((1 + R)N – 1) = ($20,000 x 0.01 x 1.0136) ÷ (1.0136 – 1) = $664.29

Since Ben and Lucy will make 36 payments, the total payment over the life of the loan is:

36 x $664.29 = $23,914.44

The total interest is the difference between the total payment and the original principal:

$23,914.44 − $20,000.00 = $3,914.44

How Interest Rates Are Applied in Non-Amortizing Loan Payments

Non-amortizing or interest-only loans are different from amortizing loans in that you don’t make any payments on the principal until a lump sum is required. As a result, the principal doesn’t decrease over the life of your loan.

This type of loan may apply in mortgages and home equity lines of credit (HELOCs).

The interest-only loan is typically based on an adjustable interest rate, and borrowers only pay the interest rate for the initial years (a low “teaser” rate). Since the interest rate is adjustable, it rises and falls based on the Libor rate (the London Interbank Offering Rate). The Libor rate is the rate that banks charge each other for short-term loans.

The “teaser rate” period may last three, five, or ten years. During that period, the principal doesn’t decrease with each payment.

When the interest-only period ends, lenders give several options:

  • Paying off your loan balance at once.
  • Refinancing the loan, if refinancing is available.
  • Beginning to pay off your balance in monthly payments at higher amounts than the interest-only payments.

The interest rate may also increase after the teaser rate period.

To calculate the payments during the teaser rate period, multiply the original principal (the amount you borrowed) by the annual interest rate, and divide by the number of payments in a year.

Here is an example:

For a $100,000 loan with a 6% interest rate, the monthly payments during the teaser rate period will be: ($100,000 x 0.06) ÷ 12 = $500 monthly payment

How Different Types of Interest Rates Affect the Cost of Borrowing

The cost of your loan can vary based on the type of interest rate given by lenders. Therefore, find out what type of interest rate applies before taking a loan.

  1. Simple Interest

Simple interest means interest paid or computed on the principal only of a loan.

It provides a quick and simple method of calculating the cost of borrowing. To calculate simple interest, multiply the daily interest rate, principal, and number of days between payments.​

Interest (I) = principal (P) x time (T) x interest rate (i) 

With simple interest loans, the monthly payment first goes toward the particular month’s interest, and the remaining amount goes toward reducing the principal. This way, you pay each month’s interest in full so it doesn’t accrue.

The simple interest rate may also be fixed or variable. A fixed interest rate remains the same for the entire loan term, while a variable interest rate changes over time.

  1. Compound Interest

Compound interest is also referred to as interest on interest. That’s because lenders add any accrued interest amount on your loan to the outstanding principal, and apply the interest rate to the now larger principal.

The frequency of compounding will determine the rate at which compound interest accrues.  A higher number of compounding periods leads to greater compound interest. For example, the amount of compound interest accrued on $200 compounded at 10% semi-annually will be higher compared to $200 compounded at 20% yearly, over the same time period.

Some common loans, like federal student loans and mortgages, typically don’t have compounding interest, as long as your monthly payments cover the accrued interest for each period. If your monthly payments don’t cover the monthly interest, your overall loan balance may grow (referred to as negative amortization). Here, lenders add the unpaid interest to your principal balance, and the interest rate applies to that larger outstanding balance.

Because interest can add up quickly, you should find out how interest accumulates, and if or when it compounds, when you apply for a loan. 

The following formula shows how to calculate the total amount you will pay at the end of a loan term with compound interest:

A = P x (1 + r/n)n x t

A = the total amount you will pay at the end of the loan term

P = original principal (the amount you borrow)

r = annual interest rate

n = number of times the interest compounds every year

t = loan term (the total number of years)

Here is an example of the calculation:

If Alexa takes a loan of $1,000 with a 5% interest compounded monthly, this is the total amount that she will pay after 15 years:

A = P x (1 + [r / n])n x t

A = 1,000 x (1 + [.05 / 12])12 x 15

A = 1,000 x (1.00417)180

A = 1,000 x 2.11497

A = 2,113.70

After 15 years, Alexa will pay a total amount of roughly $2,114. Of that amount, $1,000 is the initial amount Alexa borrowed, while the remaining $1,114 is interest.

Many credit cards compound interest daily on your average daily balance if you carry over a balance on your credit card from one month to the next. The typically high credit card interest rate and daily compounding can make paying off your debt difficult. Fortunately, credit card issuers charge zero interest if you pay your balance in full each month.

In situations where you cannot pay the credit balance in full, at least try to pay off the interest on the outstanding balance every month. This way, the balance will not increase. If you pay less than the accrued interest, your balance will increase over time; but, if you pay more than the accrued interest, your balance will reduce over time.

  1. APR

APR (annual percentage rate) reflects your loan interest rate plus all other related fees (including broker fees, rebates, closing costs, discount points, and others). It’s a more effective way to compare the cost of different loans than simply considering the interest rate. The APR is often expressed as a percentage.

The APR is greater than or equal to the nominal interest rate, except in specialized deals where lenders offer rebates on your interest expense.

To calculate the APR of a loan, you need three numbers: the amount borrowed, the term length of the loan, and the total finance charge.

APR = ({[F ÷ L] x N} ÷ n) x 100

APR = annual percentage rate (expressed as a percentage)

F = finance charge (the cost of borrowing, including interest and all fees)

L = loan amount

N = number of days in the year

n = loan term in days

As an example, here is the calculation of the APR on a $1,000 90-day term loan with a $400 finance charge:

APR = ({[$400 ÷ $1,000] x 365} ÷ 90) x 100 = 162.2%

How Interest Affects the Overall Cost of Borrowing

Now that you understand why interest rates vary for different borrowers, how the interest rate is calculated and applied to loan payments, and the different types of interest rates, you can better appreciate the impact interest rates have on loan costs.

Here are several other situations where interest rates can affect the overall cost of borrowing.

Interest During Deferment or Forbearance

Deferment is a period during which lenders temporarily suspend borrowers’ regular payments. Similarly, forbearance is a period during which lenders temporarily reduce or suspend borrowers’ regular payments.

You may still be responsible for repaying the interest accruing during a deferment or forbearance. Here, the interest rate may only apply to your loan’s principal balance. However, the accrued interest can be capitalized (added to your principal balance) when you start making payments, making your interest rate applicable to the larger principal balance.

Because of capitalization, you may wind up paying more overall if you defer your payments.

Interest During Nonpayment or Late Repayment

Interest typically continues to accrue during nonpayment or late payment. When you resume payments, less of it will be applied to the principal balance because of the accrued interest. As a result, you will likely take a longer time to reduce the loan principal and pay more interest on your loan.

Interest During Loan Term Extension

You may have slower progress in paying off the principal balance if you reduce your monthly payment through a loan term extension (increasing the repayment term). This is because lenders apply loan payments first to the interest, so a smaller monthly payment means a smaller reduction in your principal balance.

When you extend the term, your principal balance stays at higher levels, longer, which increases the total interest you’ll pay over the life of the loan, since the interest is calculated on your principal balance.

Interest During Early Repayment

You may have faster progress in paying off the principal balance if you increase your monthly payment by making an early repayment (reducing the repayment term). This is because a higher monthly payment puts more money toward reducing your principal balance.

Your principal balance reduces faster, which reduces the total interest you’ll pay over the life of the loan because interest is calculated on your principal balance.

Interest During Grace Periods

A grace period is a period during which your debt isn’t accruing interest or lenders don’t penalize you for late payments. Depending on the lender and the loan type, grace periods can last from a few days to a few weeks. Some loans may even have a grace period of several months. 

Grace periods can help manage the cost of borrowing by avoiding late fees and high interest.

Conclusion

By understanding how interest rates are calculated, you can make smart borrowing decisions. With this type of knowledge, you can determine how much a loan will cost, and even know how that can change in case of late payments.

In case you have difficulties calculating interest rates in amortized loan payments, compound interest or APR, you can use one of CreditNinja’s loan calculators or contact our Customer Care Team to assist you.

Through these insights, you have a better understanding of the critical aspects to consider when taking out a loan.

References:

https://www.bankrate.com/loans/personal-loans/rates/
https://www.experian.com/blogs/ask-experian/do-deffered-payments-affect-credit/
http://www.youcandealwithit.com/borrowers/trouble-paying/postpone-payments.shtml
https://www.experian.com/blogs/ask-experian/how-compound-interest-works/
https://www.consumerfinance.gov/ask-cfpb/what-is-an-interest-only-loan-en-101/
https://www.investopedia.com/articles/managing-wealth/042516/how-interestonly-mortgages-work.asp
http://www.math.hawaii.edu/~hile/math100/consf.htm