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Understanding How Loan Rates Work

The percentage of the principal amount that the lender charged you when borrowing is called an Interest Rate.

The same situation as your banks, they are paying you interest because they are using the money that you deposited from them to fund loans.

Just like any business, banks will charge higher interest when you borrow from them compared to their depositors. Banks are competing with each other over the depositors and borrowers, hence all the advertisements you see. The competition also helps the people as it helps keep the interest range in check.

How Interest Rate works

A bank or a lender would apply interest rate on your unpaid total portion of your loan.

Even if you’re unable to pay the principal amount, you must at least pay the interest to avoid increasing your outstanding debt. When a bank thinks that it’s unlikely the debt gets repaid, they are going to charge you a higher interest rate. That’s the reason why credit cards usually have high-interest rates, making it difficult and expensive to manage.

There are two types of rates that banks offer – fixed or variable rates, depending on the loan.

Fixed rates have it in the name. It remains the same throughout the entirety of your loan. Your first few payments on the loan go to your interest and as time goes on, you pay an increasing amount of percentage to your principal debt. Making an extra payment would do wonders in getting the debt paid off sooner. Variable rates on the other hand, change with the prime rates. Whenever the prime rate rises, so too will your payment on the loan. That’s why it’s very important to keep an eye on the prime rates.

APR vs Interest Rates

Let’s start by discussing what an APR is. So the APR stands for “Annual Percentage Rate” which allows you easily compare the cost of borrowing different loans. The APR includes everything such as the fees, interest, and duration of the loan. Both have different functions. The interest rate will tell you how much you need to pay each month while the APR will give you the total cost of the loan.When interest rates are high, loans will generally cost more. Thus making people and business borrow less. Demand will fall and companies will sell less, meaning the economy will shrink, if it gets worse – it might turn into a recession.

If the opposite happens and interest rates fall, people and businesses would borrow more, boosting the economy. Just like the opposite, too much increase in interest would cause inflation.

So in short, interest rates affect how people spend their money.

When looking around for loans, you essentially shop for rates. Different accounts and different loans come with different interest rates, depending on many factors including the bank that is offering the loan, the term of your loan, and several other market-based factors.

How is interest calculated?

Interest, is essence, is basically the fee that you pay for borrowing money from financial institutions like banks. The annual interest rate, then, is the percentage of what is charged by the institution.  

Now when the bank charges the interest, they charge it on the total outstanding balance of your loan. For this reason, it is imperative that you pay at least your interest fee each month, else your debt total amount will increase.

Policy interest rate 

One of the very first factors that affect how a bank charges interest on a loan is the interest rate policy. In economics, there is the monetary authority which determines the money supply of a given currency in an economy. The monetary authority, is then, also responsible for setting the interest rate. This authority aims to regulate inflation and interest rates.

High risk vs low risk

The level of the interest rate of a specific loan or account depends on the risk, of which financial institutions are always trying to mitigate. For high risk loans such as loans that are worth way more, interest rates tend to go high. The same also applies for loans that are not secured by collateral such as personal loans. There is a bigger risk that borrowers will not pay since no property was submitted as collateral.

Borrowers are also assessed by looking at their risk profile. This is where the credit history comes in handy. If you have an excellent credit score then this proves your creditworthiness. This means you are a low-risk borrower and financial institutions like banks are more inclined to offer you lower interest rates.