Loans
3 mins
Everything You Need to Know About Interest and Loans
Author
Danny Randell
Published
Jan 24, 2024
What is a Loan?
A loan is any amount of money borrowed by an individual or corporation from a lender (such as a financial institution) that has to be paid back. Usually, the lender charges interest on the loan, which makes the arrangement beneficial for both parties.
What is an Interest Rate?
An interest rate is a number (usually expressed as a percentage) used to signify the amount of money calculated as owing to a lender at the end of an agreed-upon term.
How Does Interest Work?
If you borrow money from someone and you agree to pay them back with interest, you’re essentially saying that in exchange for instant access to cash, you will pay them back more than the amount you originally borrowed. The interest is simply the amount of extra money “on top” of the amount you borrowed.
How much interest you may pay to a lender can vary widely, but it is almost always calculated as a percentage of the total loan amount. For an example of this, see below:
Real World Example of Interest on a Loan
Let’s say you borrow $10,000 from a bank to help you purchase a used car.
The bank agrees to loan you the money for 5 years pending you pay it back with interest.
In this case, the interest rate is 7% (prime rate of 2% + 5%).
Now, for each year you hold that loan, you’ll be charged 7% in interest. (How this generally works is you will make monthly payments rather than save up $10K + interest to pay back in five years time.)
So in the case of the above, you’ll make monthly payments of $198 for 5 years until all of the loan + 7% interest is paid back to the lender.
This works out to be a total of $11,880, meaning in all, you’ll have paid $1,880 in interest to the lender in exchange for them extending you a $10,000 credit.
What Does Compound Interest Mean?
Compound interest is a phenomenon whereby the interest (or money “on top” of the amount you borrowed) is multiplied. Think of it as interest earned on top of interest.
Investopedia explains: “Because compound interest includes interest accumulated in previous periods, it grows at an ever-accelerating rate.”
Because of this “ever-accelerating rate”, compound interest can work wonders on your savings account. However, when it comes to debt, compound interest is nobody’s friend. In fact, compound interest can trap you in a never-ending cycle of trying to pay off a loan that just keeps growing, and is something you should watch out for when applying for a loan.
How to Get a Loan
Applying for a loan is usually a fairly simple process, and can be done at most financial institutions. Many banks, for example, can approve people for loans in a single sitting, sometimes even over the phone.
Before you head off to get a loan though, you will want to think about how much funding you’ll need, and check out the current interest rates to get an idea of what your payments might look like. There are tons of loan calculator tools on the internet you can use to get an idea of what a loan might cost you in interest.
You may also want to check your credit score in advance of booking a meeting with a loan advisor. Knowing your credit score can give you some insight on what amount you’re likely to be approved for; that way, you won’t run into any surprises during the application process.
