When you are about to get a loan, be it a mortgage, auto loan, student loan, etc, you will have to pay interest on it.
If this is the first time you’re getting a loan, you need to understand how loan interest works so you are well informed before you make such a choice. So, how does loan interest work?
Interest on loans will vary based on the type of loan you get. More so, interest isn’t charged the same way for every loan. For example, credit cards will charge you interest on an outstanding balance that you haven’t paid on time. Personal loans, on the other hand, will charge you interest on a lump sum, regardless of whether you pay on time or not.
But there’s more to it. In this article, I will define interest for you and then I will explain how it works in more detail. I will also explain what the difference between interest and APR is since many people are confused about these two.
Let’s get started right away!
What’s Interest?
In simple terms, interest is the price you pay for a loan, expressed as a percentage of the amount of the specific loan you receive. In other words, it’s what a creditor will charge you for the privilege of getting a loan.
You can also view interest as the cost you are charged for being able to use someone else’s money.
While interest is the cost of borrowing money, it is also the profit a lender makes for taking the risk to lend to you. That’s why, in a sense, when you deposit money in the bank, they will pay you interest; you basically allow them to use your money for investing. It’s not technically a loan that you give them, but the interest the bank pays you to deposit money is a shared characteristic here.
Also, interest usually refers to an amount that is charged annually, but it is also calculated for both longer and shorter periods.
How Does Interest Work?
Now, as a borrower, you will need to give back the money you borrowed but you will also need to compensate the lender for the risk they take to give it to you through paying interest on the loan.
This is fair if you think about it; not only do they take a risk, but they also cannot use that money in some other way when they have lent it to you. That’s why you end up paying back more than you borrowed.
To see how interest is usually charged, though, we will need to talk about two different types of debt here…
Revolving Debt
Think of revolving debt as a revolving door; money comes out when you borrow and comes in when you pay it back at the same time. All debt that isn’t limited to a specific lump sum that can be borrowed and to a specific period that it needs to be paid back is revolving debt.
Credit card debt is like that; you can keep borrowing while paying back some outstanding balance. At the same time, there is no agreed-upon amount of debt (although there is a limit called “extended credit”). And there is also no specific period you need to pay the money you borrowed back.
What also defines credit card debt is the insanely high interest rates. On top of that, the longer you wait to pay off credit card debt, the more the interest will compound.
Last, credit card debt is unsecured which means that you are not required to provide an asset as collateral to get access to this kind of debt.
Installment Debt
On the other hand, we have installment debt which involves borrowing a fixed amount of money as a lump sum and having a specific predetermined date when the debt will have been paid off.
In contrast to revolving debt, you cannot keep borrowing funds from your creditor as you pay off the balance. Think of student loans, mortgages, auto loans, personal loans, etc.
Another important difference here is that installment debt can be secured. If you get a mortgage, for instance, you may be asked by the lender to secure the loan by using your home equity as collateral.
What’s the Difference Between the Interest Rate and APR?
What most people get confused about is the difference between the interest rate and APR. Further, many believe that they’re both one and the same, just expressed differently. This isn’t true, though.
We already defined what interest is; the cost of borrowing money. APR (Annual Percentage Rate), however, is the annual cost of borrowing money and it includes more costs than the interest rate. What’s common here is that both the interest rate and APR are expressed as percentages.
The other costs the APR might include are charges like mortgage insurance, loan origination fees, closing costs, discount points, etc.
The advantage to using APR, instead of just the interest rate, is that it allows you to do an apples-to-apples comparison between debt costs provided by various lenders.
Conclusion
As you see, understanding how loan interest works isn’t hard. But it’s necessary to know all of the ins and outs before you get yourself into debt.
You don’t have to become an expert on how debt works, but you do need some basic knowledge like I provided above so you can be more confident in your financial decisions. It’s your income we’re talking about here, after all…
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Thanks for reading and I’ll talk to you next time!
Disclaimer: This information should not be viewed as financial advice. You should consult a financial advisor or do your own due diligence before you invest. The owner of this website and author of this article are not to be held liable for any undesired result by anyone who uses this information that is provided here in any way.
