One of the most confusing aspects of taking out a loan is figuring out exactly what the interest will cost. Several different types of interest exist, and individuals should try to have a basic understanding of each of these categories before they even begin shopping for a loan—and certainly before signing any loan agreement. In the most basic sense, interest refers to the cost of borrowing money, for anything from paying tuition to buying a home. Generally, interest is a percentage of the amount borrowed, but not every lender will offer the same terms. Typically, interest is expressed as an APR, or annual percentage rate, which also includes loan generation fees. Sometimes, lenders will quote the headline rate, which is the cost of interest alone.
The Difference between Simple and Compound Interest
When looking for a loan, it’s critical that people know the difference between simple and compound interest. Very few lenders offer simple interest, but understanding how it is calculated is important for seeing how compound interest adds to the overall cost of a loan. With a simple interest rate, the interest is charged only on the principal. With this type of loan, individuals can find the total interest charge by multiplying the interest rate by the loan amount and then length of the loan.
For a simple example, take a $10,000 loan that will be paid back in two years with an annual interest rate of 5 percent. Here, the loan recipient will pay $500 in interest per year for the loan. Over the course of two years, the total interest paid will be $1,000 since the rate is charged on an annual basis. When looking at simple interest rates, it is important to look at the timeframe. A monthly interest rate of 5 percent would result in a much higher overall cost.
Compound interest means that, at a certain time, outstanding interest is added to the principal, which increases the overall amount of interest a borrower pays. In the example given above, suppose that the interest is compounded annually. The total interest paid for the first year would remain $500, but then the second year’s interest would be based on a total principal of $10,500, so the total for that year would be $525. In the end, the borrower would end up paying $1,025 instead of $1,000 because of the compound interest. This scenario assumes that the borrower makes no payments on the loan, which is often the case with student loans, but not necessarily with home or auto loans.
When looking at compound interest loans, individuals should see how often the interest is compounded because smaller intervals—such as monthly ones, for example—will drive the total amount of interest paid up even further. Looking at compound interest makes it evident how valuable it can be to pay interest up front and avoid it carrying over into the principal.
Many loans that people will get today, such as personal loans, mortgages, and car loans, are amortized. When a loan is amortized, individuals pay a fixed monthly payment calculated up front, but that allocation of that money changes each month. A simple way to think about it is that the monthly payment covers all interest due first and then the remaining amount goes toward the principal. In the beginning, most of the payment goes toward interest, with only a small amount cutting into the principal. However, as the principal goes down, so does the interest due since it depends on the outstanding principal. Toward the end of the loan, very little of the payment is going toward interest, with the majority going straight to the principal.
When a loan is amortized, individuals can reduce the overall amount of spending for the loan by increasing their monthly payments above the minimum. Depending on the fine print of the loan, money spent beyond the minimum monthly payment should go directly toward the principal, which means that less interest will be generated for the next monthly payment and even more money will go toward principal. Individuals should always verify with their lenders where extra money is going because some companies require written directions to apply it toward the principal. By spending a little extra each month, individuals can pay their loans off much earlier and spend significantly less on interest.
Fixed Versus Variable Interest Rates
The other major consideration when looking at interest is whether the rate is fixed or variable. With a fixed rate, individuals lock into a rate at the very beginning of the loan term, and this rate stays the same for the entire life of the loan. This type of loan is common for long-term agreements, such as a mortgage. A variable interest rate can change over time, typically in concert with an established index like the 11th District Cost of Funds Index or the Cost of Savings Index. These rates change at predetermined intervals, usually monthly.
People should consider several factors when looking at fixed versus variable interest rates. Often, individuals prefer a fixed rate because they will not suddenly have to pay more money should the index increase. However, this means that the payments will also not go down, as they could with a variable interest loan. Often, the current state of the market determines which option is best. If the market is currently high, individuals may want to consider a variable-interest loan so that they do not stay locked into the high rate. If the market is low, a fixed-rate loan may make more sense because the market will likely only go up. Often, the market is somewhere in the middle, and predicting its direction can prove difficult. When the interest type that a borrower has chosen becomes particularly problematic, borrowers might be able to refinance to a different structure.