The Principles of Interest

One thing for certain when it comes to getting financing is that credit is not free. Lenders charge money when they extend credit for loans, mortgages, credit cards and other financing. The cost of borrowing is called interest; the amount of interest charged depends on several factors. Over time, consumers will pay tons of cash in interest, which is why it is an important aspect to consider in making money management decisions.

Two basic parts of most types of credit account payments are principal and interest. Principal is the amount borrowed, which can mean the price of an item (like a car or house) or the amount of credit used (as in credit cards and credit lines). Interest is the cost the lender charges the borrower to extend credit, which is where some borrowers get confused or pay more than they bargained for.

What the Numbers Mean

Getting a complete understanding of the complex details of interest may not be fun, but it can sure help the consumer get a firm grip on their bottom line. Knowing how interest rates work equips borrowers to make sound decisions on issues such as:

  • Choosing a lender
  • Shopping  for the best interest rates
  • Whether to pay off debt
  • If credit terms are acceptable

Paying interest is an unavoidable part of the borrowing process. There are differences in types of rates which may seem complicated and result in borrowers making decisions that do not benefit them financially. Breaking down the numbers will provide a working knowledge of how interest is calculated. There are two basic types of interest for most transactions as follows:

Simple interest

This is the easiest way to calculate interest that will be charged on a loan. It is determined by multiplying the interest rate by the principal then multiplying that number by the number of payment periods. A simple interest calculation is P (the principal or loan amount) x I (interest) x N (loan duration).

For example, if a consumer takes out a loan for $50,000 at 5% interest for a term of one year, the price he would pay for the loan (interest) is $2,500. The total amount he would pay for the loan is $52,500 (50,000 x .5 x 1), plus any fees that are included in the loan agreement.

Simple loans are commonly used for auto loans or some types of personal loans. The payments go toward the interest first and then the principal. Interest for any given month is paid in full. By contrast, some types of rates accrue, or accumulate, interest. This is called compound interest.

Compound Interest

Compound interest adds a portion of the monthly interest back into the principal loan balance. Each month, new interest is added to old interest. It is calculated on the principal amount as well as interest accumulated in previous months. There is a huge difference in how much interest is paid using simple interest and compound interest. However, compound interest is a real advantage when it comes to receiving interest from savings or investments.

In some cases, lenders will only approve a loan based on compound interest, which can be expensive. This is especially true with carrying balances on high interest credit cards. For instance, a credit card with a balance of $10,000 that is carried over at a 20% monthly compounded interest rate can mean paying interest charges of about $1900 in one year.

Annual Percentage Rate

The annual percentage rate (APR) for credit is usually a little higher than the base interest rate because it includes loan fees. Lenders disclose the APR to give borrowers an idea how much the loan will cost in total. People that are shopping for a loan or credit card should compare options using the APR so they can get the total cost of a loan at a glance with one number. The APR is calculated as follows:

  • This number is divided by how many days it will take to repay the loan.
  • That number is multiplied by 365 and again multiplied by 100. 
  • All fees and interest paid over the term of the loan are totaled.
  • The loan amount is divided by that number.

Since performing this calculation can be confusing, it would be easier to look carefully at the APR in the information box of the loan agreement rather than just the basic interest rate. The methods of calculation, as well as number of interest compound periods, have an impact on the amount of monthly payments. Calculations also vary by country.

How Interest Rates are Determined

No matter how the interest is calculated, the rate determines how much money the loan will cost. Lower interest rates are not a small matter; they can save tens of thousands of dollars over years of making credit payments. Typically, lenders set the interest rate for a borrower based on three factors:

  1. The base rate. This is a percentage set by central banks in each country, to be used as a guide to set credit prices.
  2. Lender policies. Each creditor has their own rules and parameters when it comes to approving credit. Major bank and lending institutions are commonly more stringent in their credit approval requirements.
  3. The borrower’s credit history. Borrowers with excellent and good credit scores usually get the best APRs, fair scores get lower offers, bad credit scores result in getting the highest interest rate for approvals or credit denial.

Interest Based on Credit Product

There are some variances in interest depending on the type of loan. The application process, interest rates, and number of options can be diverse for each product and lender. Some examples of the differences include:

Auto loans

It is important to get a clear understanding of the terminology on an auto loan credit agreement. Although most auto loans are calculated with simple interest, title fees, sales tax, and dealership fees could be added into the APR. Borrowers might be able to negotiate the fees or pay them upfront to save money in interest paid on those items over the course of the loan.

Credit cards

There may be several interest rates for credit cards. Rates for credit cards depend on the type of balance that the borrower is carrying. Other factors that may change the rate are how the cardholder is managing the account, fees for balance transfers or cash advances, and cards with an introductory low annual percentage rate offer.

Mortgage Loans

Since the term of a mortgage loan is long and the debt is higher, interest costs can be expensive. The APR on most mortgage loans include items like mortgage insurance plus origination fees and taxes, which can impact the total interest paid.

Getting a complete understanding of interest rates takes time and focus that pays off. Not all factors that determine interest rates are under the control of the borrower. But it is possible to get the best rates by controlling those that are, such as maintaining good credit. This starts with getting a credit report. Any mistakes on the report should be fixed, while making all payments on time. With credit in order and principles of interest understood, borrowers will have financial leverage when it’s time to apply for credit.

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Smarter Loans Staff

The Smarter Loans Staff is made up of writers, researchers, journalists, business leaders and industry experts who carefully research, analyze and produce Canada's highest quality content when it comes to money matters, on behalf of Smarter Loans. While we cannot possibly name every person involved in the process, we collectively credit them as Smarter Loans Writing Staff. Our work has been featured in the Toronto Star, National Post and many other publications. Today, Smarter Loans is recognized in Canada as the go-to destination for financial education, and was named the "GPS of Fintech Lending" by the Toronto Star in 2019.