An interest rate is more than a just financial charge that you have to pay when borrowing money. Interest rates, first and foremost, are used to control the market and as a way to guard against inflation. Not only do they affect the housing market, but they also affect all the different types of credit available in today’s financial market. Unless paying cash for a mortgage, vehicle, or another major purchase, you more than likely will also be paying interest, on the item.
However, when people take out a loan, most will now enough about loans and how they work to apply for a low-interest personal loan, but there is more involved with an interest rate than hiking up your monthly payment at the end of the month. Understanding how interest rates work is especially important, especially when taking on debt such as a personal loan.
Continue reading to learn more about the importance of understanding personal loan interest rate.
Table of Contents
1. Calculating Simple Interest
Of all of the elements involved in understanding interest, calculating simple interest is probably one of the easiest things to understand. Everyone remembers the interest rate formulas of our formative educations. Well, that principal x rate x time formula that yields the interest that would accrue in a saving account over a certain time is the same one used to calculate interest on a personal loan.
The formula actually looks like this: principal x rate x time = accrued interest. This formula can be used to calculate how much interest will be paid out in each monthly payment and how much interest will be paid out over the entire life of the loan.
2. Calculating Annual Percentage Rate (APR)
Another word you might hear in lending is the annual percentage rate or APR. The APR differs from simple interest in that the interest rate greatly influences your monthly payments and the APR is just the yearly cost of the loan including fees related to opening the loan. Discount points, loan origination fees, broker fees, and mortgage insurance all make up the APR. While consumers should understand all loan rate terms, there is a real advantage to understanding this term. The APR works when you are trying to determine whether one loan works better than another.
As opposed to simply comparing interest rates, you can get a better idea of how much the borrowed money will end up costing you in the long run. This figure is very important for a few reasons. Firstly, it ultimately determines how much you spend over the actual value of the loan. For someone who purchases a home or a car, the cost of the purchase is more expensive than had the person made the purchase with cash.
In the case of a home where its value appreciates, this is not such a big deal. With a vehicle, however, its value is going to depreciate, and this is where the interest rate can really affect the items total cost.
3. Calculating Annual Percentage Yield (APY)
Finally, while more often than not you will find APY as a part of the interest–bearing account, there are instances when this interest rate will be applied. As opposed to calculating interest monthly, APY is accrued over a year, even though it is compounded monthly. Typically, though, you only see APY when you are lending the banks money, i.e. saving money.
4. Understanding Personal Loan Interest Rates
These are just of the few terms associated with interest rates and lending. The simple interest rate is what we often associate with borrowing, but APR and APY are other types of interest that affect borrowing. In understanding what these rates are and how they affect the total loan, will be better able to find those great loan deals.