Interest rates can be super confusing, and online ads don’t make it any easier. Many ads for loans suggest that using their company will give you peace of mind, but their APR rating is through the roof. To make sure you don’t get caught in a contract you cannot pay back, we are going to explain interest rates.
What Are Interest Rates?
When you borrow money, you have to pay the lender for the original amount plus interest. The interest is the cost of using their service. The amount of interest will depend on the lender and on your credit score. Some lenders will give you a flat interest rate, so you know exactly how much you will need to pay back, and others will provide you with a percentage that changes the monthly payment.
This means that if you borrowed $1,000 from a bank with a flat interest rate of 10%, you would have to pay back $1,100.
How Do Interest Rates Work?
There is always a base rate enforced by the government, but depending on the lender and your credit score, different companies can offer you different rates.
If your credit score is high, this means you are seen as good with money. The lenders will note this and give you a lower interest rate, knowing that you are not a risk.
If your credit score is low, you will come up as a red flag to lenders, suggesting that you may not pay them back. To make sure they get some money back from you, the interest rate will be higher.
If you want more information on how banks calculate interest, CreditNinja breaks down how banks set interest rates.
What Is APR?
APR stands for Annual Percentage Rate. It is made up of your interest rate and additional fees, for example administrative fees, late payment fees and so on.
You can use APRs as an excellent benchmark to compare with other companies. Loans with higher APRs are likely to accept people with lower credit scores, because their rates will cover the risk. However, you have to weigh up your own risk level due to their hefty charges.
How Does Compound Interest Work?
Compound interest is when additional interest is added to a loan that has already been charged. This means that if you did not pay off your loan as you should, the compound interest will charge you more than it would have, creating a late payment deterrent.
For example, if your loan is worth $1,000 with a 1% compound interest and 10% interest rate. The bank may tell you to pay the 10% interest rate as a minimum.
Before the interest hits, you pay $100, dropping the loans down to $900. The 10% interest is then laid on bringing you back to $990, and then the compound interest is applied, taking you up to $999.90
You need to be aware of the compound interest to ensure you reduce your loan.