Interest is the price you pay in percentage form to borrow money from a lender. As you pay back your principal balance each month, you also have to pay back interest, which does add to the overall cost of your loan. There are two primary types of interest, and it's important to know the difference between the two when it comes to calculating your rate.
Simple interest
Simple interest is the easier of the two to calculate and short-terms loans tend to have simple interest rates. To calculate the total interest you will pay over the life of your loan multiply the principal amount by the interest rate and the lending term in years.
Amortized interest
Amortized loans tend to be more complicated. The initial payments for amortized loans are typically interest-heavy, which means that more of the payments are going toward interest than the principal loan balance. As you get closer to the end of your repayment term, more of your monthly payments go toward the principal balance and less toward interest. To calculate the amortized rate, complete the following steps:
- Divide your interest rate by the number of payments you make per year
- Multiply that number by the remaining loan balance to find out how much you will pay in interest that month.
- Subtract that interest from your fixed monthly payment to see how much of the principal amount you will pay in the first month.
- For the following month, repeat the process with your new loan balance.
Mortgages, auto loans, student loans and personal loans are typically amortized loans.
Factors that affect how much interest you pay
There are several things that impact the interest rate you are eligible for as well as the overall interest you end up paying on an installment loan:
- Credit score. The better your credit, the more likely you are to qualify for a lender’s lowest interest rates. Your credit score indicates to lenders how likely you are to pay back a loan. If you have bad credit, you are likely to receive a higher interest rate so that the lender can make sure it makes its money back even if you default on the loan.
- Debt-to-income ratio. If you have a high amount of monthly debt compared to your income a lender is likely to assign you a higher interest rate. If you currently have several high interest loans, it could be worth looking into debt consolidation in order to lower your monthly payment and simplify your bills.
- Loan amount. The more money you borrow, the higher your interest rate will be. When you take out a large loan, the lender is taking on more risk than if you were to take out a smaller loan. To cut down on interest, make sure you only borrow what you need.
- Loan term. Shorter loan terms come with higher monthly payments, but you end up paying less interest overall. Longer repayment terms come with lower monthly payments, but you end up paying more in interest.
- Type of loan. Loans can either be secured or unsecured. Secured loans tend to have lower interest rates because they are backed by collateral. However, that does mean that you risk losing an asset such as your home or car if you fail to pay back the loan.Personal loans are typically unsecured, meaning that they tend to have higher interest rates than secured loans.
How inflation affects interest rates
The higher the rate of inflation, the higher interest rates will typically trend. Similarly, if inflation is slowing, interest rates tend to drop, too. This is in part because banks anticipate the decreased purchasing power of the interest earned during periods of high inflation.
To get the lowest possible interest rate on your loan, compare top lenders before you apply. If possible, prequalify with a few lenders to see what terms you are eligible for without making a commitment or undergoing multiple hard credit checks within a short period of time.
