Interest is the price you pay to borrow money. Once you take out a loan, you’ll need to repay the principal or the amount you originally borrowed plus interest. Since there are several types of interest rates out there, such as fixed interest, variable interest, and simple interest, it’s important to understand what they are and how they might affect you when you move forward with a loan.
Fixed interest is the most common type of interest. It’s fixed, meaning it stays the same over the life of the loan. This makes it easier for you to calculate your overall interest charges and budget for your monthly payments well in advance. A fixed-interest rate loan is a fairly straightforward way to borrow money.
Variable interest rates are not set in stone. Instead, they fluctuate based on the market or “prime interest rate” that lenders use to set their rates. If you commit to a variable interest rate loan, your rate will likely increase or decrease throughout its life. You may find it difficult to repay your loan when your rate goes up, especially if you’re on a tight budget or face an unexpected event like a job loss or car repair that impacts your cash flow.
Annual percentage rate (APR)
The annual percentage rate refers to the actual yearly cost of a loan, expressed as a percentage. Unlike a fixed interest rate or variable interest rate, it includes other fees and charges from a lender. An APR can give you a clearer picture of how much you’ll pay for a loan in the long run.
A prime rate is the interest rate that banks charge their most creditworthy customers. Simple interest is calculated only on the principal amount or the initial investment. For example, if you have a $1,000 loan at a 10% simple interest rate, you would only owe $100 in interest after one year. The prime rate is often used as a benchmark for other loans, such as home equity lines of credit and credit cards. In general, the higher the prime rate, the more expensive loans will be for borrowers.
Simple interest rate
The simple interest rate is a lot like it sounds: simple. It’s interest that is only calculated on the principal of a loan. When possible, opt for a simple interest loan, as it lowers the cost of borrowing and makes it easier to repay what you owe. Simple interest-rate loans can be personal loans, traditional mortgages, and auto loans.
Compound interest rate
Compound interest is interest that accumulates on both the principal and accrued interest from previous periods. It’s often referred to as “interest on interest.” While compound interest can come in handy when you invest money, it will increase your overall cost of borrowing. That’s why you should do your best to avoid compound-interest loans.
When you do your research and compare loan options, interest types should be top of mind. After all, the interest rate you land will determine how much you’ll have to repay and how manageable your monthly payments will be.
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