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Loan Interest- Definition

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Loan interest is defined as a fee for borrowing money. This fee is often calculated as a percentage of the loan amount. That percentage is added to your agreed payback amount.

What Does Loan Interest Mean?

When you borrow money from a bank or other money lender, such as Power Finance Texas, they will typically charge you an extra fee in the form of interest for using their money.

Interest appears as a percentage rate on your payment agreement or bill. This percentage is based on your loan amount and other factors the lender may consider. When you look at your repayment statement, these numbers are expressed as principal (the original amount loaned to you) and interest (the user fee for borrowing that money).

How is Interest Calculated on a Loan?

Loan interest payments can be calculated in multiple ways. One way is simple interest, where the payments are divided evenly over a clearly defined time period. Another is compound interest, where the payment fluctuates depending on the principal balance owed, like with the variable balance on a credit card.

Simple Interest

Simple interest is a straightforward calculation based on the original amount of money you borrowed. The interest is set, and the payments do not vary–unless the interest rate changes–until the entire amount is paid. Here is an example of simple interest.

If you borrow $100, you and the lender must agree on how and when the money will be paid back and how much the lender can charge you for borrowing the money.

Let us assume you agreed to this: You will borrow $100 (principal). You agree to pay it back over the next four weeks. You have also agreed to add an extra 10% (interest) to the total amount you owe the lender.

Let’s do the math.

You borrowed $100 and have four weeks to pay it back.

$100 ÷ 4 weeks = $25 a week

This means you need to pay at least $25 each week to pay the principal amount back in time.

Now, let’s figure out how much you will pay in interest. Remember, you agreed to pay back 10% more than the original $100 loan. 10% of $100 is $10. That $10 will be divided up over the four-week loan period.

$10 ÷ 4 weeks = $2.50 per week

The $25 weekly principal plus the $2.50 weekly interest means you will pay $27.50 per week or $110 by the end of the four weeks.

$25 a week (principal) + $2.50 a week (interest) = $27.50
$27.50 x 4 weeks = $110

Compound Interest

This type of interest allows the bank or other lender to charge you for the total amount of the loan (principal) plus the interest accumulated from previous periods. The interest compounds over time and can sometimes be called “interest on interest.” The longer it takes to repay the loan, the more interest you will pay. It is a good idea to look for the lender’s (or similar lender’s) compound interest loan calculator to ensure you understand exactly what your payments and interest will look like.

Are there Different Types of Loans and Loan Interest Options?

Here are some of the common types of loans you may hear about.

Credit Loan

A credit loan is the type of loan you receive when you apply for a credit card. There is a set amount of money available to you. It can be borrowed from in any amount and paid back appropriately as often as needed. The amount you pay changes each month based on how much you owe, with the interest calculated on that amount.

Installment Loan

Installment loans are a set amount of money with a specific payment timetable. You know exactly how much you owe in principal and interest and how much you must pay each week, month, or year to pay off the loan. Installment loans include most car and home loans, personal loans, and payday advance loans. This is the type of loan offered by Power Finance Texas.

Secured Loan

This type of loan is granted based on collateral, such as your car or home, that can be used to repay the loan if you do not meet your payment agreements. You agree that if you cannot repay your loan, the car or house will be given to the lender to satisfy your debt. If your loan is not connected to anything else you might offer as payment, the loan is considered unsecured.

How Do Lenders Decide on a Loan Interest Rate?

inspecting interest rates with a magnifying glassSome loans have a set interest rate for everyone. Most will have a specific number calculated for each borrower. There are several things a money lender will take into account when deciding interest rates. These might include:

  • Your income
  • Your assets
  • The amount of money you already owe lenders
  • How well you’ve paid back past loans

If the lender decides you will likely repay your loan on time, they consider you a “low risk” and may give you a lower interest rate.

If the lender is worried you might not be able to repay your loan, they would consider you a “high risk.” This often means they will charge you a higher interest rate to try and ensure they get their original loan amount back more quickly.

APR (Annual Percentage Rate)

An annual percentage rate (APR) is the cost you pay yearly to borrow money, including fees expressed as a percentage. Yearly average of what lenders think they need to charge to earn money on their lending investments. This number may remain the same for the entire time you have the loan, or it may change over time.

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