If you’re in the market for a personal loan, you should develop a strong financial vocabulary to better understand your options.
Interest Explained
Interest is the price you pay a lender to borrow money. Businesses, even banks, are in the business of making money, so they charge interest to make a profit. Interest rates are reported in percentages, such as 8.99%, 12.25%, or 24.71%, and reflect a percentage of the principal, or the amount of money you borrow, each time interest accrues.
Simple Interest
When you take out a short-term loan, including many payday loans, personal loans, and auto loans, you pay the amount you initially borrowed, the principal, plus an additional fee that is calculated as a percentage of the principal for the life of the loan.
This type of interest is called simple interest and can be calculated using this formula:
principal loan amount x interest rate x loan term = interest
For example, a 5-year $5000 personal loan at 12.25% interest would cost a total of $8062.50.
$5000 principal x .1225 interest x 5 years = $3062.50 interest
As long as you make your payments on time every month, the principal and interest will not increase, and you will not be charged more than $3062.50 to borrow $5000.
Compounding Interest
A similar loan with compounding interest increases the principal every time it accrues. Lending institutions can calculate compounding interest daily, weekly, or monthly, so the principal can grow rapidly over time.
Most credit cards, student loans, and mortgages are subject to compounding interest. When taking out a loan with compounding interest, it is important to pay off the loan as quickly as possible to avoid paying additional interest fees.
Key Takeaways
When you are looking for a loan—a payday loan, a personal loan, or a mortgage
Look for the lowest interest rate.
Opt for a loan with simple interest when possible.
Pay your monthly payment on time and in full every month.
If you must obtain a loan with compounding interest, pay it off as soon as possible.
APR Explained
Many borrowers confuse APR, or annual percentage rate, with interest rate when comparing loans. While they are very similar, they are not synonymous.
Like interest rate, the annual percentage rate is also expressed as a percentage. However, it includes the interest rate plus any lender or origination fees, closing costs, and insurance that may be added to the principal of your loan.
Many loans are expressed using APR, but mortgages and home equity loans are typically the only types of loans that incur origination fees, closing costs, or insurance. When in doubt, ask your lender if there will be any additional fees added to your interest rate.
Key Takeaways
Interest rate and APR are not synonymous.
APR includes interest plus any other fees.
How to Get the Best Interest Rate on a Personal Loan
Now that you know the difference between interest rate and APR, you want to know how to ensure the best rate possible when applying for a loan.
Use these tips to qualify for a reasonable interest rate on a personal loan:
Know your credit score.
Do not apply for a loan or a credit card if your credit score is less than 580. Every time you apply and are denied a loan, your credit score is negatively impacted, making it increasingly difficult to qualify for a loan with a reasonable interest rate.
Raise your credit score.
Improve your credit score by paying your bills on time. On-time payments are the single most important factor in calculating your credit score—up to 35% of your overall score. If you can’t pay your credit cards in full every month, don’t miss the minimum payment.
Pay off your credit cards.
Revolving debt, such as credit card debt, contributes significantly to your credit score as well. Your credit utilization ratio, the difference between the amount of credit you have available and the amount of debt you carry, should demonstrate your ability to obtain and pay off loans on time.
Borrow less.
Lenders calculate the difference between how much money you make each month and how much money you owe to lenders. Higher monthly payments increase your debt-to-income ratio (DTI), making it harder to get a loan. Aim for a DTI of 36% or lower.
Ask about discounts.
Many lending institutions offer discounts when you sign up for automatic bill payment. With automated payments, lenders ensure they get their payments on time, and you build better credit by never missing a payment.
The most important thing you can do to improve your financial future is be informed. Learn to manage your money, decrease debt, improve your credit score, and build lasting wealth by reading blogs, listening to podcasts, and speaking with knowledgeable financial professionals like the experts at AMG Finance.
