Loan Interest Rate: What it is and How it Works

online loan interest rate explainedNothing in life comes for free, which includes borrowing and lending money. At some point or another, most likely when you go about applying for a loan, apart from fees you’ll probably hear about something called an interest rate.

Generally speaking, every type of loan, whether home, car or personal loan — will charge an interest rate of some kid. That rate will vary depending on the type of loan, the lender, and factors such as the borrower’s credit score.

Interest Rate Definition

An interest rate is an amount a lender charges a borrower in return for providing them with a loan. The interest rate is expressed as a percentage of the loan principal, and usually, it’s in annual terms.

It is applied as either a fixed rate or a variable rate, the former being more favorable of the two:

  • A fixed interest rate is where it remains constant throughout the life of the loan.
  • A variable interest rate is where it fluctuates depending on underlying benchmark rates.

The Importance of an Interest Rate

The interest rate on any loan you borrow is a crucial factor to be aware of, this is because it is a primary component in determining how much that loan will cost you over time.

That being said, the lower the interest rate is, the less interest you’ll pay for the loan in the long run. This means it’s a good idea to seek out the lowest interest rate you can. Maintaining a good credit score will play a huge part in securing a good interest for a loan.

How Interest Works

When paying off an outstanding loan, the standard process is that you will be required to make monthly payments. The total amount of each monthly payment will include repayment of a portion of the outstanding balance on the loan, in addition, the amount of any interest that is due.

Bear in mind that the interest rate is usually expressed as an annual rate, even though your payments will typically be made on a monthly basis.

The interest rate applies to the outstanding balance of the loan if you take out a loan the initial interest rate that you are charged applies to the entire loan amount. As you pay down the outstanding loan amount, you’ll only pay interest on the remaining amount you still owe.

The formula for determining how much interest the borrower pays is as follows:

Interest = Principal x Interest Rate x Number of Periods

Impact on Credit Score

Maintaining an optimal credit score will go a long way in securing a good interest rate on a loan. It’s a known fact that banks charge higher rates to customers they consider higher risk. It’s important to know what your credit score is and how to improve it if you are concerned.

The higher your score, the lower the interest rate you will have to pay. There are many ways to improve your credit score or maintain an already good one, this will greatly increase your chances of securing a good interest rate on a loan someday!