Interest, also referred to as an interest rate, is a set amount of money borrowers pay to lenders in exchange for their loan funding. Usually expressed as an Annual Percentage Rate (APR) on loans, interest can significantly impact how much money borrowers end up paying back for their loans.
What is Interest?
When people borrow money, lenders charge a certain amount against their loan balance as a kind of fee for the loan funding. Depending on a borrowers’ credit, loan terms, state of residence, and more, interest rates can vary between percentages with one, two, or even three digits.
Interest also exists as a sort of incentive for financial institutions to lend out money to people. Since lending money does come with risks, such as customers defaulting, interest allows lenders to earn money as people pay back their loans.
The Different Kinds of Interest: Simple and Compound
There are two main kinds of interest: simple and compound. Simple interest is when the interest rate charged to a borrower comes from the principal loan balance alone. You can calculate the simple interest using the following formula: Simple interest = P x I x N. In this formula, P is the principle, I is the daily interest rate, and N is the number of days in between each payment. Loans like some personal loans, small installment loans, and auto loans usually come with simple interest.
Compound interest is when the principal loan amount and accumulated interest from any previous payments determine the interest rates. With compound interest, the amount of money borrowers pay with each loan payment usually gets larger and larger with time. Because of this, people typically favor loans that come with simple interest rather than compound interest. Forms of funding such as student loans, mortgages, and most personal loans typically use compound interest.
What Can Affect Interest?
A few different factors can affect how much interest borrowers have to pay back on their loans. And different loans also tend to carry different interest rates. You will likely see different rates for a mortgage than you will for online cash advance loans. Here are a few examples:
Loan Balance
A borrower’s loan balance is perhaps the most influential factor when it comes to how much they’re paying in interest. The larger a loan balance, the more money used to calculate against when coming up with the interest rate.
Payback Terms
How long it takes a borrower to pay back their loan can also impact the interest they pay. For example, assuming the loan balance and set interest rates are the same, someone with a loan with payback terms set for six months will likely pay less overall in interest than someone with a loan with payback terms set for one year.
Credit Score
Borrowers with a credit score on the higher end are often considered less of a risk for lenders. As a kind of reward for having good credit, lenders often offer borrowers with high credit scores lower and more convenient interest rates. This is why it’s so important to maintain good credit scores.
State Laws
Some states have specific minimums, and maximums lenders are legally bound to when setting borrowers up with interest. These state interest minimums and maximums can also vary depending on the type of loan as well.
How Can I Save On Interest?
Interest rates can have a major effect on how much money people pay their lenders during the life of a loan. It’s no wonder people are always looking for ways to save on interest. Here are a few tips that could help you pay less in interest:
Work on Building Your Credit
When lenders determine the interest they charge, they usually consider a borrower’s credit score. Normally, the lower the credit score, the higher the interest rate lenders will tack onto a loan. By building your credit and raising your credit score, you increase your chances of being offered more affordable interest rates on loans.
Pay More Than your Monthly Minimum
If you are able, it’s a great idea to pay more than the minimum amount due on your loan payments each month. By making larger payments, you are chipping away at your total loan balance faster, which means there is less money to charge against when calculating interest. Paying more each month can not only help you save on interest, but you may be able to pay back your loan faster too!
Make your Loan Payments on Time
Lenders usually charge an additional late fee when borrowers make loan payments late. This late fee amount is usually just added to the borrower’s overall loan balance, which increases the amount of money used to calculate their interest rate. Avoid these extra charges that can increase your interest rate by making loan payments on or before their due date.
How Can I Earn Money with Interest?
While interest is typically an amount that borrowers pay their lenders in exchange for loan funding, you can also earn money by lending money to yourself in a way. Certain accounts like savings accounts or a certificate of deposit (also known as a CD) can allow you to earn money each year simply by having money in your account. For example, say you had a savings account with $1,500 that pays a 5% interest rate with simple interest. Over the course of 1 year, you would earn $75 just by having money in your account, raising your balance to $1,575!