How do Interest Rates Work and How are they Calculated?

Simply put, interest rates are the cost of borrowing money.

A loan, such as a car loan or a mortgage, gives you the ability to purchase the car or home now, rather than having to save up until you can afford it. Credit cards give you the ability to purchase goods and services, such as hotels and flights. Without these loans, far fewer people would ever be able to become homeowners.

However, the lenders must be compensated for the risks they take in lending people money. This compensation is the interest the lender charges on your loan. It is a percentage of your debt.

Factors affecting interest rates

The interest rates on your loan will depend on the risk the lender calculates for that loan. These risk factors include the length of the loan, the rate of inflation, and your own credit situation. It is always important to do your research when applying for any kind of credit to make sure you understand exactly how much borrowing will cost you in the long term and make sure you are getting the best deal possible.

Long term loans are usually seen to have a higher risk for the lender, as the borrower has more opportunities for defaulting. Thus, longer term loans usually have higher interest rates.

Also, the rate of inflation, which is the increased price of goods and services over time, is another factor in the higher interest rates for long term loans.. Inflation usually rises in a healthy economy, meaning that a dollar today will be worth less in five years.

The only factors under your control are who you choose to borrow from and your credit score. A good credit score means you may be offered lower interest rates, as the lender is confident you will not default. Conversely, poor credit scores could mean prohibitively high interest rates if you are offered a loan at all. It’s essential to maintain a good credit score by paying all bills on time and staying out of debt. If you are financial distress, you should take immediate steps, such as by consolidating your loans in a consumer proposal to regain financial control.

Interest rate calculations

The calculation for simple interest, or flat rate is simple.

SIMPLE INTEREST = The amount you borrowed x Interest Rate (ie 12% monthly interest = 0.12) x Amount of time you are borrowing the money (ie if 12% is your monthly interest and you are borrowing for 2 years this number would be 24).

However, you will almost always be paying compound interest, which is calculated differently as it is the flat rate plus interest and fees. This means that when you are charged monthly interest or fees, the next month they are also subject to interest. Basically, you are paying interest on your interest. As this is the way almost all banks, lenders, and Revenue work, interest costs can become a significant part of a loan so it is always advisable to pay off your debts as quickly as you can.

It can also sometimes be helpful to focus on the creditor with the highest interest rate and then focus on the lower interest creditors if you cannot afford to pay everyone at once.

For loans such a vehicle loan, where the total amount you borrowed initially will not change (unlike a credit card), the lender will often disclose the total cost of borrowing in the contract. If they do not, feel free to ask so you will not have any surprises that you have not planned for in your budget.

Source used in researching this article include How Stuff Works: How Interest Rates Work