How Does Loan Interest Work?

When you take out any type of loan, the bank that extended the money to you will charge interest on the borrowed sum. To understand how much the financing fees will be, you must know the interest rate and the term, as well as how the interest will be calculated. The higher the rate and longer the term, the more the loan will cost you in financing fees.

Depending on the loan, the interest may be fixed or variable. When it’s fixed, the rate remains constant over the entire loan term. When it’s variable, the rate can fluctuate based on the index, such as the LIBOR or prime rate. If that rate changes, so too will the variable rate on your loan.

There are some key differences between the types of available loans, however. Here is how loan interest works among the most common loan products.

Personal | Auto | Mortgage | Student | Payday | Deferred Interest

You can take out a personal loan from a bank to pay for all kinds of things, from financing a vacation and paying for home repairs to consolidating multiple high-interest debts into one loan with a lower rate.

Personal loans are most often unsecured but can also be secured by assets. The repayment term is typically between 12 months to five years, and you would repay what you borrowed in equal monthly installments. Interest rates may be fixed or variable.

To calculate the interest, most lenders use the monthly periodic rate, which is the annual percentage rate (APR) divided by 12. Each time you make a payment, a portion of your payment goes toward the principal and the rest goes toward interest.

For example, if you took out a $5,000 personal loan with a three-year term and an interest rate of 6%, you would pay $475.95 in interest.

With a car loan, the debt is always secured by the vehicle, and the interest rate is almost always fixed.

A lender can calculate interest for a car loan in a couple of ways: simple and precomputed. If it’s a simple interest loan, interest is front-loaded and amortized. That means the interest fees will decline as you pay the car loan off, so you would pay the most in interest in the first month and the least in the last.

For example, if you borrowed $30,000 for a car with a five-year term and at a 3% APR, the total interest paid would be $2,344. But if you shorten the term by a year and seven months by increasing the payment amount, you could save about $300 in interest.

Auto loan interest can be simple or precomputed. You can save money on a simple interest loan by paying the loan off early.

On the other hand, with the precomputed interest method, the amount of interest is already determined and calculated on the initial balance. For this reason, you will pay the same amount of interest each month and with every payment. Since the same ratio of interest is already built into the loan, you won’t get a break if you pay the loan off early.

Mortgages are loans you take out to pay for a home, with the property securing the amount you borrow. The lender will charge interest on the loan, which can be a fixed or an adjustable rate.

The interest on mortgages compounds, which means it is calculated on the initial balance. The unpaid interest from the first period is added to the principal, and so on and so forth. Because mortgages are typically in the hundreds of thousands of dollars, the interest fees accumulate dramatically, especially when the rate is high and the term is long. In fact, the interest fees can be larger than the loan amount itself.

For example,  a $200,000 mortgage with a 6% APR over 30 years will cost $231,676 in interest. But if you paid it over 15 years instead and the rate is 4%, the interest cost would be $66,287 — a huge savings.

Most loans require you to start repaying the debt right away, usually 30 days after funding. But with subsidized federal student loans, you can freely wait until the grace period is up because the government will be picking up the interest costs. After the grace period ends, interest will be calculated and added to the debt.

The federal government will also assume the interest during a period of deferment.

But if you have an unsubsidized student loan, the interest will start accruing the day the money is disbursed. You don’t have to send the payments until the grace period is up, but the balance will be higher when you start paying because the interest will have been added to your total balance.

The difference between subsidized and unsubsidized student loans is when the interest starts accruing on the loan balance.

Student loan interest amortizes, so the amount of interest you pay over the duration of the loan will lessen as the months pass. The standard repayment time frame for federal student loans, subsidized and unsubsidized, is 10 years.

For example, if you took out a $40,000 loan with a 10-year term and a 4% APR, the interest fees would be $8,598. Pay it off in five years instead, and the interest would drop to $4,200.

If you need a little extra money to buy groceries or another small essential, you may consider borrowing funds from your future paycheck. The interest of a payday loan works in a unique way — it’s expressed as a flat fee, which is usually limited to between $10 and $30 for every $100 borrowed.

So, if you take out a $300 payday loan, the fees that are deducted may be between $35 and $90.

Of course, you are contractually obligated to repay the loan, plus the finance fees. The term is generally two or four weeks. If you don’t have that money when it’s due, you may be able to extend it for another term — but you will be charged another round of fees.

The converted interest should be enough to give you pause before taking out a payday loan, according to the Consumer Finance Protection Bureau. A $15 fee per $100 borrowed equates to an annual percentage rate of almost 400% for a two-week loan.

Some of the more exciting loans are those that offer deferred interest. Retailers such as furniture and appliance companies typically provide them to qualified customers.

All you need to do is make the monthly payments and satisfy the entire balance in full by the contractual time frame and no interest will be added at all. The loan is technically free!

Deferred interest loans offer you 0% interest for a promotional period. If the loan isn’t repaid before that period expires, you’ll incur interest on the original purchase price.

The problem arises when you don’t pay the entire loan by the end of the deferral period. In that case, all the interest you would have been charged during the loan term becomes your financial responsibility, and the store will bill you a large lump sum.

For example, imagine you took out a $7,000 loan to purchase new furniture, payable over two years, with a deferred interest rate of 22%. If you pay off the entire loan amount by or before the deferment period ends, it wouldn’t cost you anything in interest. But if you still owe money — even if it’s $1 — you may be hit with a $1,715.53 bill.

As you can see, there are major (and minor) differences with regard to how loan interest is calculated. Run the numbers prior to pursuing any loan. You’ll want to be sure you can handle the payments over the entire term, and that you’re OK with the amount you may potentially pay in financing fees.

The good news is that you can minimize the overall loan cost with a simple strategy: Build a credit rating that’s attractive to lenders so you can qualify for a loan with the lowest interest rate, avoid long payment terms, and borrow only the amount you need.