When you borrow money, lenders typically charge interest. Generally, the lower the APR (annual percentage rate) that is charged, the better for the borrower.
On the flip side, if you have money in a savings account, you will typically get paid interest on your deposits. In this case, you profit the higher the interest rate is!
What is an Interest Rate?
Interest is a charge someone pays in order to borrow money. This applies to almost all such transactions. Whether you borrow money to buy a home, a car, or a college education, you will pay interest. It’s not just individuals, either. Businesses can also take out loans, and they will also pay interest.
The interest rate is considered the cost of debt for the person taking out the loan. It is also considered to be the lender’s rate of return. It is normally applied to the principal – where the principal is defined as the total amount that was borrowed.
Most people who borrow money will notice that the cost of the original loan will be lower than the total they need to pay to repay the loan. That is because the total repayment reflects the cost of the interest.
Low and High-risk Borrowers
A lender will evaluate the borrower before deciding to lend money. Depending on how the lender assesses the risk is involved in loaning money to a particular borrower, three things may happen:
- The borrower is considered low risk. In that case, he or she will be given the best terms – lower interest rates and other accommodations.
- The borrower is considered to be at higher risk but still within a range that the lender is comfortable with. In that case, the borrower will be charged a higher interest rate and may not get other advantages. For example, with a credit card – a higher risk borrower may have a lower limit on what he or she can put on the card.
- The borrower is considered too high a risk. In that case, no credit will be issued.
Because your credit score is used to evaluate whether you qualify for a loan, you need to make sure that you have an excellent or good rating if you want to borrow money.
Calculating How Much You Owe
Let’s say you buy a house. If you had a simple interest rate, it would be relatively easy to calculate how much you would pay, in total, for the loan. You would simply calculate the principal times the interest rate times the payment period.
However, most banks charge compound interest for a home loan. The amount charged is much more complex – it is the principal times [(1 + interest rate) summed over a factor of compounding periods – 1]
As you can imagine, calculating this over a period of 360 months (the length of time of a 30-year mortgage) can be quite complex. That is why credit calculators exist. SoFi offers a range of products to help you wisely manage your money, including a credit card monthly interest calculator that can make managing your debt a lot easier!