• Interest Rates 101: Not Knowing How Interest Works Could Cost You Big Time

    By mtokhmanian | October 13, 2014

    By Ben R.

    LoanMart Financial News

    Los Angeles, Calif. – Do you read the fine print? Probably not. According to an NYU study, out of 50,000 people, only 0.11 percent read the terms of service on websites.

    That’s right. There’s a zero and a point before that 11.

    Checking the fine print is important in everything from warranties to service agreements; however, not doing so can have an even more long-term effect on your financial well-being when it comes to loan terms. This is especially true in regards to interest rates.

    LoanMart, the premier auto title loan lender strives to make the loan process as simple as possible by being transparent with its customers regarding their auto title loan terms. However, knowing what type of interest is used to calculate the interest on a loan isn’t very helpful if the customer doesn’t know how it works. Therefore, this article will endeavor to break down what for some is the mystical world of interest.

    What is interest?

    While Merriam-Webster lists multiple definitions of the word “interest,” the one applicable to this article is, “a charge for borrowed money, generally a percentage of the amount borrowed.”

    This straightforward answer belies the fact that there are multiple types of interest rates, each with their own mathematical formula. Further, these rates fall under two types of interest: simple and compound.

    Simple interest

    This is called simple interest because of the relatively easy way in which it’s calculated. Using a formula from Investopedia Simple Interest = Principal x Interest Rate x Term of the Loan. For example, let’s say a person borrowed $10,000 at a fixed rate of 3 percent interest for four years:

    10,000 x 0.03 = 300

    300 x 4 = $1,200

    That means each year the interest payable on this loan is $300, totaling $1,200 over the four-year term (assuming all payments are made on time).

    Compound interest

    This type of interest, on the other hand, is not as easy to calculate.

    “Compounding interest is where interest is charged on your principal balance, and then that interest is tacked onto the principal balance,” said Bill S., LoanMart’s Training and Development Manager. “The lender then charges interest on that new larger amount. It’s interest charging interest on interest.”

    This is where the math gets tricky. If the rate is compounded monthly, for example, a person would have to calculate 1/12 of the interest rate multiplied by the principal. In the example we used for simple interest, we figured out the annual interest was $300. In that case:

    1/12 x 300 = 25

    So in the first month, $25 would be tacked onto the principal balance – $10,025. Now it gets messier. For month two, you would find 1/12 of 3 percent of $10,025. Then month three would be 1/12 of 3 percent of $10,050.06. And so on.

    What type of interest is better for a loan?

    While many lenders do charge compound interest, the best for the consumer is simple interest. For starters, the math is less difficult. But the main reason is the amount of money the customer will save in interest.

    “From an investment perspective, you’d want compounding interest,” Bill said. “The interest accumulates faster than simple interest, and it’s all being added to your principal balance.

    “However, simple interest is better for buying something versus compound interest,” he added. “Simple interest is only charging interest on the unpaid principle balance. That’s why we use that interest rate calculation at LoanMart; we don’t want to charge you more than we have to.”

    The important thing to find out from the lender is the exact annual payment rate (APR). Knowing the lender’s method of calculation and, if it’s compounding interest, the number of compounding periods will help the customer calculate his or her monthly payments. Having this knowledge before signing loan documents could save customers a lot of stress – and a lot of money – by allowing them to smartly negotiate better terms or go with a different lender.

    Whatever type of interest the lender uses , however, the customer’s focus should remain on paying down the principal as quickly as possible, Bill said.

    “Pay it off early, or pay a little bit more per month to go toward reducing that principle balance,” he said. “That’s what the interest charges are based on. No matter what rate you have, it is focused on that principal balance.”

    (This is part one of a two-part series on interest. Check back soon for part two, which will focus on fixed versus variable rates.)

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