What You Should Know About Interest Rates
The “Interest rate” is the price of money. In other words, an interest rate is the amount that a lender charges to loan out money—it’s designed to be high enough to cover the risk and fees involved in making a loan. Certain loans have very low risk and thus very low interest rates, like mortgages. Personal loans to people with low credit ratings have more risk, so they tend to have higher rates.
Like any price, sometimes the amount you pay is worth the services you receive, and sometimes it is not.
What is APR?
Interest rates are usually expressed as annual percentage rates (APR). This is the rate you would pay if you borrowed money for an entire year, without paying any of it back.
Let’s look at how it works with a payday loan. You pay $15 to borrow $100 for two weeks—an interest rate of 15%. That’s not the annual percentage rate, though. APR is the interest calculated over a full year.
And, if you don’t repay any part of the loan, the amount owed can become huge. Let’s suppose you take out a payday loan with a 15% fee on the first of the year. You roll it over every two weeks without paying off any of the amount borrowed. Look how quickly the total amount grows: in two months, you owe more money than you borrowed.
Initial Amount Borrowed
Total Amount Owed
Total Interest Owed
January 1, 2016
January 14, 2016
January 28, 2016
February 11, 2016
February 25, 2016
March 10, 2016
March 24, 2016
April 7, 2016
What happens is that you are charged interest on outstanding interest. It’s a phenomenon called compound interest, and it is incredibly powerful. Or, as the bankers like to say, those who do not understand compound interest are doomed to pay it.
Buy the numbers
In almost all states, the interest rate on a loan must be quoted as the annual percentage rate (APR) to help you compare the rates being offered by different lenders. The equation used to calculate it is:
(1 + r)t = 1 + APR
It’s not as hard to calculate as it might seem. The r in the equation is the interest rate charged each period, written as a decimal, and t is the number of time periods in a year. So, if the interest rate were 3% a month, you would find the APR to be 42.58%.
The problem is that some lenders charge rates that are well above what they need to make to offset their risk. The payday loan, with 15% interest charged every two weeks, has a huge APR:
(1 + .15)26 = 1 + 36.76
That number, by the way, is 3,676%. Yikes!
Usury is the practice of charging excessive rates of interest. It is outlawed in many states, but not all. Even states that regulate interest set a maximum rate, but some lenders charge less. That’s why it’s pays to shop around.
Now, the compound interest calculation assumes that you can roll the loan over every two weeks without paying off even part of the principal, and that’s not going to happen. One way to reduce the total amount of interest paid is to make regular payments of both principal and interest.
Build a better credit score
The other way to reduce the amount of interest paid is to build a better credit score. That reduces the risk to the lender, which means that the rate charged will be less.
One way to build your credit is to make regular, on-time payments on your debts. If you take out a personal loan, make sure the lender reports on-time payments to credit unions, this can help build (or repair) your credit.
Understanding interest rates can help you make smarter financial decisions in the long run. It’s information that you can use to improve your financial future.
OppLoans is the nation’s leading socially-responsible online lender and one of the fastest-growing organizations in the FinTech space today. Embracing a character-driven approach to modern finance, we emphatically believe all borrowers deserve a dignified alternative to payday lending. Currently rated 5/5 stars on Google and LendingTree, OppLoans is redefining online lending through caring service for our customers.