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All Your Questions About Loan Interest Rates

Author: Michael Williams

If you think interest rates don't really matter -- think again. Interest rates have a huge impact on your finances. Whether you're taking out a loan or depositing money into a savings account, interest rates will influence the amount of money you ultimately walk away with.

How Are Interest Rates Determined?

A number of different factors are used to set interest rates. Generally speaking, the following four factors have the most influence on the interest rate you're granted by a financial institution:

1. Current Economic Conditions

Factors such as the strength of the economy, inflation rate and the stock market play a large role in setting interest rates. When the economy is strong, interest rates tend to rise. Conversely, they decline during periods of weakness, as the Federal Reserve often artificially lowers interest rates during these times to stimulate the economy. Interest rates also tend to increase when inflation rates rise, as lenders want to ensure they will be sufficiently compensated for the adjustment.

2. Terms of the Loan

The loan itself can have an impact on the interest rate offered. Specifically, the amount, type and term of the loan all factor into the interest rate. For example, typically longer-term loans often come with lower interest rates, whereas shorter terms come attached with higher ones.

3. History with Lender

Many lenders offer discounted interest rates to established customers, as an incentive for choosing to do repeat business with the financial institution.

4. Credit Risk

Lenders review your credit report prior to making a decision on whether or not to grant you a loan. Interest rates are determined based on your overall credit risk, including your employment status, credit score, credit history and income. Lower interest rates are typically given to borrowers with a low credit risk.

Whether you're taking out a loan or depositing money into a savings account, your funds are greatly impacted by the interest rate you're granted. Even one seemingly small percentage point can make a difference. For example, if you're granted an auto loan using simple interest -- more about this below -- for a total of $20,000 at an APR of 3% over five years, you will pay $3,000 in interest. However, if your interest rate rises just one point to 4%, you'll pay a thousand more in interest over the life of the loan.

Calculating Simple vs. Compound Interest

Simple interest is preferred by borrowers, as it allows them to pay lower interest fees. Calculations are based on the original principal amount, rather than also charging interest on the interest accrued during the period of the loan.

Four different variables are used to calculate simple interest, including:

  • I: total amount of interest accrued
  • p: original principal balance of the loan
  • r: interest rate
  • t: time period of the loan in years

For example, the interest calculation on a loan of $100,000 at a rate of three percent over a six-year period would read: I = ($100,000)(0.03)(6) as I = (p)(r)(t).

The total interest paid or I would be $18,000.

Conversely, compound interest is computed based on previously accrued interest. Rather than simply paying interest based on the principal amount, interest is calculated on the total outstanding balance.

Five different variables are used to calculate compound interest:

  • S: future value of the balance
  • P: original principal amount
  • r: interest rate
  • n: number of times interest is compounded per year
  • t: total time period of the loan in years

For example, the interest calculation for a $100,000 loan with an interest rate of three percent, compounded annually over a six year period would be:

S= ($100,000)(1+0.03)^(1)(6) as S= (P)(r/n)^(n)(t)

S= ($100,000)(1+0.03)^(6)

S= $119,405.23

The total interest paid would be $19,405.23.

It's easy to see why borrowers would prefer a simple interest calculation -- in this calculation, they'd save $1,405.23 by going that route.

Where Are Simple and Compound Interest Rates Used?

Simple and compound interest rates can apply to both loan and deposit accounts. Financial institutions may use them as an incentive to attract customers.

Simple interest is commonly used in installment loans, where one fixed amount is paid for the duration of the loan. For example, simple interest is commonly used in auto loans.

Compound interest is typically used in savings accounts, making it easy to earn money on your balance. Many high-yield savings accounts offer daily compounding interest to entice investors to keep their money in the account, effectively maximizing their investment.

While compound interest can work in your favor in a deposit account, taking out a loan under these terms can be very costly. In fact, compound interest is generally used by credit card companies, which is how a relatively small balance can quickly become significantly larger if not paid off in a timely manner.

So, pay attention to interest rates the next time you're opening any type of account. Whether you're taking out a loan or depositing money into a deposit product, you'll be impacted by the interest rates on the account.

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