How Interest Rates Work

When considering a loan, you will be confronted with a variety of terms that can confound the consumer into not really knowing what the actual costs of borrowing will be. Before heading out to talk with a lender, take some time to understand the language of interest rates and how they are computed.

At the very basic level, there are two types of interest rates exist when borrowing money: simple interest and compound interest. Simple interest is calculated by multiplying the principal (P), or amount borrowed, by the rate (r) over the life of the loan (t). The formula for simple interest is straightforward: I = Prt

This formula will give you the interest (I) that will be paid over the life of the loan. Add that to the amount that was borrowed, divide by the number of payments, and you will know the total cost, plus how much you need to budget for each payment.

Compound interest is calculated by applying the interest rate to the principal and then adding the unpaid interest into the amount owed. At the next interest cycle, or compounding period, interest is calculated again, this time on the amount that includes that added interest. Compound interest results in a benefit to the lender, but means the borrower is paying more for the loan than a borrower who received a simple interest loan. The more compounding periods will result in higher overall interest paid for the loan.

When you choose a loan, the lender is required by the Federal Truth in Lending Act of 1968 (TILA) to provide disclosures relating to percentage rates, costs, and calculations used to determine the value of the loan. The federal requirements vary according to the types of loans, for instance credit card revolving accounts or mortgage loans. Part of this disclosure requirement is a notice stating the APR, or annual percentage rate of the loan. APR includes items not included in the quoted rate of the loan such as origination fees, points, prepaid items such as mortgage premium insurance, and closing costs. Lenders may quote a monthly interest rate that does not include these items abut they combine to form the true costs of borrowing. The nominal APR is calculated by multiplying the principal by the rate by the compounding periods. The effective annual rate (EAR) or effective APR is calculated using the additional fees and costs of the loan in addition to the principal.

The effective interest rate or annual percentage yield (APY) is another term you may hear when considering a loan. This rate takes into account the compounding within the year and is generally higher than the APR. When a loan is compounded, you are essentially being charged interest on to of interest. If you are looking for an investment or savings vehicle, this is the number you will want to know to have the best idea of what you will earn. A six-month CD (certificate of deposit) with an APR interest rate of 10% will yield an APY of 10.48% on a deposit of $1000.

You may also have to decide between a fixed rate and adjustable rate loan. A fixed rate is just that, it is fixed at a certain percentage for the life of the loan. An adjustable rate loan is riskier, because as a consumer, you are betting on rates lowering in the future, resulting in a lower overall cost of borrowing. However, if rates go up, you may be hit with a higher monthly payment than you can afford and paying more over the life of the loan than if you had opted for a fixed rate loan. Some consumers may opt for an adjustable rate loan during a period of falling rates with the plan of refinancing the loan to a fixed rate if conditions prompt interest rates to rise. This is where knowing how to calculate the APR and APY can help to make an informed choice, as refinancing often includes origination fees, closing costs and points that can eat up any savings of a lower rate.

The average consumer is not a math major, so online calculators are a great way to plug in your known factors to determine the APR, APY and payment amounts on various loan and savings options. Most banking websites offer these tools to assist borrowers and investors to analyze their options.

You may also have to decide between a fixed rate and adjustable rate loan. A fixed rate is just that, it is fixed at a certain percentage for the life of the loan. An adjustable rate loan is riskier, because as a consumer, you are betting on rates lowering in the future, resulting in a lower overall cost of borrowing. However, if rates go up, you may be hit with a higher monthly payment than you can afford and paying more over the life of the loan than if you had opted for a fixed rate loan. Some consumers may opt for an adjustable rate loan during a period of falling rates with the plan of refinancing the loan to a fixed rate if conditions prompt interest rates to rise. This is where knowing how to calculate the APR and APY can help to make an informed choice, as refinancing often includes origination fees, closing costs and points that can eat up any savings of a lower rate.

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