How Interest Calculated Exactly And How To Do Loan Works ?-Loan Basics

Meet Lucy.
Lucy has been working at Corporate Co. for the past three years.

Lucy wants to be like them, there’s just one problem: all these activities require loans, and Lucy just doesn’t feel confident handling them. What should she to do?

Well, her first step is simple: understand how loans work.

On their most basic level, loans are simply borrowed money. Lenders, such as banks, can give borrowers, such as Lucy, a fixed amount of money called principal, like $10,000 to buy a car. However, the bank isn’t giving Lucy this money for free. In addition to paying back her principal, they’ll require Lucy to pay a certain amount of money each month, called interest, just for using their money.

In addition, if her loan is secured, as many are due to their more attractive interest and approval rates, the bank can seize actually the asset, in this case her car, if she fails to repay.

So how is this interest calculated exactly?

Let’s explain through an example.

While this seems reasonable enough, interest rates come with three more complications:

Number One,

Not all interest rates are fixed. Some, called variable interest rates, can change over time, often quite dramatically. Because of this, they can be quite risky, especially on long-term loans.

Number Two,

The interest rate of a loan is not the same thing as its APR. APR includes both the interest rate, either fixed or variable, and the fees. Thus, when comparing loans to see which is cheaper, Lucy should always use APR, not the interest rate.

Number Three,

APRs are also highly dependent on your credit score, as the lower your score, the higher your APR. For more details on this, be sure check out our next video “Credit Scores and Reports 101”.

So that’s interest rates. But unfortunately, they aren’t Lucy’s only concern. She also must pay back a certain amount of her principal each month. This payment, combined with interest, makes up Lucy’s total loan payment, which is the money you pay the bank each month.

Should Lucy want to calculate this number herself, all she’ll need is an online calculator, like ours, and three numbers: the amount of money borrowed, the interest rate, and the length of the loan, also known as its term.

This term is a critical number, especially when choosing a loan.

That’s because, in general, the shorter the term of the loan, the greater your monthly loan payment. This should make sense. After all, the less time you give yourself to repay the loan, the more you’ll have to pay each month to compensate.

And while this may seem bad, shorter term loans can actually be great, for two reasons.

One: They come with inherently lower interest

And two: Because their monthly payments are much larger, the borrower is forced to pay down the principal much faster, which ultimately means less interest charged over the life of the loan.

This fact is so important that we’ll repeat it. The shorter you can make your loan, either through extra-debt repayments or a shorter term, the less interest you’ll pay in the long-run.

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Media Operations Manager of I’m a therapist and emotion specialist and I am passionate about helping people understand the world of emotions, I like to write about self-improvement and achieving excellence.