Interest Explained

Interest Rates – types and terminology

It can be confusing at times when confronted with all of the financial jargon associated with taking out a loan, particularly when all you really want to know is exactly how much it is going to cost you on a monthly basis.

Having said that, there is much to be gained from having a basic understanding about interest rates, the different types of interest rates that are available, and how interest rates are calculated BEFORE you enter into any loan arrangement. The more you know about interest rate formulas the better you’ll be positioned to make a more informed judgement when it comes to taking out a loan and, in doing so, ensure that you keep as much of your money in your pocket as possible.

What is ‘interest’?

In its simplest form, ‘interest’ is the cost of borrowing money, and it is normally expressed in terms of a percentage of the overall loan. Not only will you have to pay back the original amount of money borrowed (the principal), but you’ll also have to pay back the cost of borrowing that money (the interest, plus any setting up fees etc.) How much interest you have to pay on any given loan is subject to a number of different criteria, depending on whom you borrow the money from and the terms of the loan.

Fixed Rate Interest

Fixed rate interest is simply as the name suggests: a ‘fixed’ percentage of the loan must be paid back during the life of the loan. For example (using dollars as our currency), a $1,000 loan with a fixed rate of interest of 5% per annum, means that if the loan amount were to be paid off in 12 months, the total amount the borrower would pay back would be $1050. Fixed rate interest loans make it very easy to calculate the exact amount of money the borrower will have to pay back each month, as the amount never changes. Simply put, the borrower can add up the amount to be borrowed, the interest amount, and any set up fees and other charges, and then divide that amount by the number of payments to be made (the life of the loan) and he/she will be left with the monthly payments that need to be made.

Variable Rate Interest

Variable rate interest loans allow the lender to set the interest rate to whatever market conditions demand at any given time during the life of the loan. The attraction of variable interest rate loans is that you can benefit from any future drop in market interest rates, as you monthly repayments will be reduced to reflect the market changes. However, the opposite also holds true, that if the market decides it’s time for interest rates to rise, so too will your repayments. Mortgage loans, for example, are mostly set up with a variable interest rate, as it is virtually impossible to predict market conditions years ahead. In many cases you can opt for a fixed rate for a few years, and then the loan transfers on to a variable rate, but these deals vary from lender to lender. Make sure you fully understand the consequences of a variable interest rate loan if you are considering taking one out. If interest rates rise dramatically, you could find yourself in financial difficulties.

APR

APR, or ‘Annual Percentage Rate’ is the percentage of interest payable on the loan based on a yearly term. In many countries, financial lenders must disclose the APR so that consumers have the chance to measure all lenders against a common metric. For example, many credit card companies declare their interest rates in terms of a monthly interest rate, say 2%. The actual APR in this instance is 24% (12 months X 2% = 24%), which doesn’t sound so attractive. APR gives borrowers the chance to determine what the actual overall cost of the loan will be, but keep in mind that there may be additional ‘set up’ or ‘administration’ fees that are not included in the APR calculation. Particularly for smaller loans over shorter time periods, these extra fees can make a big impact.