Financial education is really important. Financial terms and rules are really confusing, and oftentimes things aren’t explained as good as they should be for the average consumer. As a result of the miscommunication, a lot of borrowers are in debt, and are committing themselves to loan terms that will not help their finances in the long run.
It is important to know what all of the terms used means, so that you can make well-informed financial decisions. Ask questions, and do your own research, because no one else is responsible for your financial choices, except for you. Having a basic understanding of interest rates will help you out with your future purchases and agreements.
What is Interest?
Interest is simply the cost you pay for borrowing money. This cost can either be a onetime fee, or a recurring fee, it just depends on the terms of your agreement. Typically you only pay interest when borrowing from a financial institution, or a lending company. However, if you borrow money from a friend or family member, they may just charge you interest as well.
What Are the Different Types of Interest?
Simple interest is calculated based on the principal amount of the loan. It is paid only one time and cannot change.
- Simple interest is calculated by the following equation:
Principal x interest rate x time= interest
Let’s say you take out a title loan for $1,500, with a rate of 25% (0.25) for 1 year, the total interest you would pay is $1,500 x 0.25 x 1= $375.
Compound interest is calculated based on the principal and any interest earned previously. Meaning that, you have to calculate the interest from each year, and then add it to the balance before adding it to the next payment.
- Compound interest is calculated by the following equation:
Principal x interest rate= interest earned, year 1
(Principal + interest earned) x interest rate= interest earned, year 2
(Principal + interest earned) x interest rate= interest earner, year 3
…and so on.
Let’s say you borrow $1,250 at a rate of 25% for a term of 2 years. At the end of the 1st year you will owe $1,250 x 0.25= $312.50 in interest. And you will owe ($1,250 + $312.50) x 0.25= $390.63 in interest. Bringing the total interest for 2 years is $703.13.
Be aware that not all compound interest loans compound annually, some compound on a month to month basis. Check with your lender to see how their interest compounds, and adjust your arithmetic accordingly.
A fixed interest rate stays the exact same throughout the course of the loan term. This rate is determined at the time of signing, and allows the borrower to know the exact amount that needs to be paid each month, because it will not change. Fixed interest rates are typically seen in large purchases/investments like home mortgages or in car notes.
Variable interest rates, you guessed it vary, payment to payment. This variation is dependent on the current index value of interest (current market conditions) at the time. These rates change month to month, and can sometimes change week to week, in either direction. If the variable interest rate gets really high, you can find yourself in a situation where you are having a difficult time with repayment.
Amortized interest rates are like fixed interest rates, where the amount of each scheduled payment does not change throughout the course of the loan term. The difference is that, as time goes on the interest portion of the loan payment decreases in value, while the principal portion goes up. Yet, the overall monthly payment stays the same.
Prime interest rates are short term interest rates, used by commercial banking institutions for their very best customers. These customers are the most credit worthy, according to their standards. The federal prime rate is currently 4.50%. Prime rates are usually for commercial businesses, but can also be applied to mortgage loans, small business loans, and even personal loans.
Discount interest rates only apply to commercial banking, other financial, institutions. It is the interest rate the reserve charges on loans given to these banking and other financial institutions, so that they can loan funds to borrowers.
You may not come into contact with all 7 interest types, but having knowledge of the few you will encounter will put you into a better position to make good financial decisions.