How Loan Interest Rates Work

The interest rate refers to the amount of money charged by a lender. When you borrow money from someone or the bank or any other financial organization, you pay interest. On the other hand, when you lend money to someone, you actually earn interest.

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There are various methods to calculate interest and some of them are highly beneficial for lenders only. Typically, the interest rate is based on annual calculation, which is called the “Annual Percentage Rate or APR.” The assets you borrowed could include consumer goods, cash, or large assets like building or vehicle.

Example of Simple Interest

Let us give you a simple example so that you understand how interest rate works. If you have borrowed $200 and agreed to the interest rate of 7% per year, then it means that you will pay $7 per year – assuming that you have used “simple interest.”

When you borrow a certain amount of money – in general – you have to pay interest. However, this might not be obvious because there is no separate bill for the costs of interest or a line-item transaction. Read on!

Annual Percentage Rate (APR)

Annual Percentage Rate or APR is generally used interchangeably with “Interest.” APR is accurate for accounts like credit cards. However, when it comes to other types of loans, it could fees that are associated with the loan – making the APR a bit higher than the actual rate of interest.

The Cost of Credit

APR provides a measurement to calculate the cost of overall credit or loan. Therefore, it is vital to take into consideration both APR and the base interest rate when you are acquiring credit cards or loans. It is always a good idea to use APR for comparing options since it allows you to calculate the total cost easily.

In order to calculate APR, first, you need to add the fees and then the interest, which is paid over the loan. The next step is to divide it by the amount of loan – and then by the number of days in which you will pay back the loan. Since APR is the annual percentage rate, you will multiply that by 365 and then multiply it again by 100.

How to Calculate an APR

We are going to give an example, which will help you understand in a better way. If you have borrowed $1000 at a simple interest rate of 2% for two years, you will have to pay a total of $40 in interest. However, when it comes to APR if you have borrowed $1000 at 2% over 2 years, but add in a $10 administration fee for the loan, you will calculate the APR as:

10 + 40 = 50
50/1000 = 0.05
(0.05/730) * 365 = 0.025
0.025 * 100 = 2.5

As you can see in the example, the APR for $200 is 2.5%, which is higher than the 2% interest rate because it has taken into account all costs. Primarily, there is only one way to lower your loan interest rate – i.e. simply to negotiate it with the lender.