When you borrow money, you agree with the lender about the interest rate. Different types of interest rates impact how much you end up paying. Here are some common interest rate types and how they work:
Simple interest rate
A simple interest rate only charges interest on your original principal. The lender calculates how much interest you will owe per year at the start of your loan agreement based on how much you borrow. As a result, you can see how much the loan will cost.
For example, say you take out a loan for $100,000 with a 4% simple interest rate that you will repay in three years. You will owe $4,000 per year in interest, adding up to $12,000 over three years. In total, you will need to repay $112,000 for this loan.
Compound interest rate
A compound rate comes into play when the lender charges interest not only on your principal but also on any unpaid interest.
For example, let’s say you borrow $100,000 with a 4% interest rate, but it compounds every year. After one year, you owe $104,000 from the original $100,000 loan principal plus $4,000 in interest. If you don’t make any payments, your principal would become $104,000. In the second year, you would owe 4% of $104,000, which is $4,160 in interest.
The amount you owe increases as you get further into debt from compound interest. That’s why paying off the principal quickly for loans with a compound interest rate should be a priority.
Compound interest and savings accounts
You can make compound interest rates work in your favor. Banks and credit unions offer interest when you keep money with them. If you put money in a deposit account that earns interest, that interest is compounded. This means as you save more, you earn more interest every year.
When you see an ad for a loan or credit card, it should mention an Annual Percentage Rate (APR). The APR shows how much you will pay per year to borrow, including the interest rate and any extra fees from the lender. The government requires lenders to post the APR so you can adequately compare how much you would owe with different loans.
Fixed and variable interest rates
A fixed-rate loan charges the same interest rate the entire time you owe money. Your monthly loan payments will remain the same.
A variable rate loan adjusts the interest rate based on what’s happening in the economy. As a result, your loan payment can go up and down over time.
If you sign up for a variable rate loan, check the loan terms to find out when your payment can change and by how much so you aren’t caught off-guard.