Read this article if you want to better understand how to calculate interest rate and how to determine the real cost of a loan. There isn't anything too complicated here, but many people don't take the time to do the math. The result is that people end up with unexpected expenses and aren't sufficiently prepared to handle the financial burden.
Whether you have good credit, bad credit, or no credit, taking the time to understand interest rates will pay off.
The Simple Math To Calculate Interest Rates
When principle, rate, and time are known, the simple formula for calculating simple interest is as follows:
Principle x Rate x Time = Interest
Add interest to the principle loan amount, and the resulting figure is the total amount you will have to pay back.
Let's use an example:
Say you borrow ,500 and agree to pay it back over 3 years at 4%.
Plug these numbers into the formula:
Principle: 3,500 x rate: 0.04 x time: 3 = Interest: 420.
The interest on this loan will cost 0, making the total cost ,920. Unfortunately, most loans aren't quite so simple. Stay with us, however, and all will be revealed.
One term that can mystify borrowers is APR or annual percentage rate. If a bank or lender talks about the effective rate of interest, remember that this is the same thing as APR, but is different from the stated rate of interest. This loan involves compound interest. Understanding what these terms mean is essential. Here's how to calculate APR. Let's look at a loan to be paid off in less than a year. Let's say you borrow 00 from a lender to be paid off in 150 days. The stated interest rate is 7%.
Now use the following formula:
Days in the Year (360 is a common figure used by banks) / Days Loan is Outstanding x Stated Interest Rate = APR (effective rate)
Plugging in the numbers looks like this:
360 / 150 x 0.07 = 0.168 (17%)
Your APR, or the rate you will actually pay for this loan is 17%. Once you know the APR, just multiply by the principle to see how much interest you will pay. On the 00 loan above at 17% you pay 4 in interest. Knowing how to calculate interest rates allows you to see clearly what the cost of borrowing will be.
Take a moment to digest the above information before continuing.
Many bank loans are based on compound interest. Always make sure that you are calculating your costs based on the effective rate, not the stated rate.
Don't stop reading, however, because there is an important difference when it comes to credit card interest rates and other short term borrowing like payday loans.
Effective Annual Rate
The concept is the same, but interest is compounded daily or monthly instead of annually. Even though credit card companies talk about APR, their interest rates are more accurately referred to as EAR, or Effective Annual Rate.
Because the math is a little bit complicated, we will only present examples here. Rest assured, the EAR will always be a little bit higher than the stated APR. A credit card with an APR of 12.99% will actually charge an EAR of 13.87% when compounded daily. A high APR will cost more. Anyone with an APR of 29.99% actually pays 34.96%.
Call it unfair, call it a stacked deck, but these are the realities of borrowing with a credit card. On top of all this, credit card companies charge late fees and transaction fees. The best way to avoid lining the pockets of lenders is to pay on time and to borrow at the lowest rates you can find.
Although it is not always possible, credit cards are most effectively used for simple convenience, to be paid in full every month.
Once you have wracked up a debt, however, you will have to play by the lenders rules until you are paid in full. Once again, the best approach is this situation is reign in expenses as much as possible and concentrate on paying the maximum each month. Debt consolidators can help facilitate this process by laying a groundwork that is easy to follow.
For many people, paying off debt is easier when they can see the big picture and chart their progress. The basic job of a debt consolidator is to find a single loan to pay off many smaller loans. Ideally, a lower interest rate is achieved, often by offering collateral like a house.
Fixed Interest vs. Variable Interest
A final note about interest rates: there are two common types called fixed and variable. A fixed rate remains the same for the life of the loan while a variable rate is tied to investments and will go up or down with the markets.
Depending on the state of the market and the direction it is moving in, a variable rate can be cheaper or more expensive. Most people struggling to get out of debt choose a fixed rate in order to simplify a complicated situation.
Despite the relatively simple math, most of us glaze over when it comes time to think about interest rates.
Even though it might not be fun, doing the numbers will be much less unpleasant than writing even one more payment check than you have to. Take the time to learn how to calculate interest rates before you borrow and always pay off your loan as fast as possible.