How Loan Interest Works

Paying interest is the cost of borrowing money. But understanding how your interest is calculated and how much money you’ll pay back in the long run can be tricky. Read through this article to better understand different types of interest rates, how they are calculated, and what to look for when you consider borrowing money.

Important Terms to Understand

Principal

This is the original amount of money you borrowed.

Interest Rate

This is the annual percentage of the original loan amount that you is added to your total.

APR (Annual Percentage Rate)

This rate, given as a percentage that may differ from your interest rate, includes any mandatory fees that may be included in addition to the interest. This rate gives you the true cost of borrowing.

How Interest is Calculated

Common loans like auto loans and mortgages use simple interest. This means the lender takes the current balance of your principal, multiplies that by your annual interest rate, and divides that number by 365 days to determine your daily interest amount. This daily amount can then be multiplied by the number of days since your last payment to find out exactly how much interest you owe.

Amortization

Most loans are structured so that your monthly payment stays the same, but the way your payment is split between principal and interest changes over time. This process is called amortization.

Early in the life of your loan, a large portion of your payment goes toward interest while a smaller amount pays down the principal. As the principal amount decreases over time, your daily interest charge decreases along with it. So later in the life of your loan, a larger portion of your payment goes toward paying off your principal.

Other Types of Interest

Although most standard loans use simple interest here are some other types of interest you may encounter.

Compound Interest

Commonly found on credit cards and revolving lines of credit, compound interest is calculated by adding the interest owed on the principal along with any accumulated, unpaid interest.

Capitalized Interest

Often associated with student loans, this is unpaid interest that is added back onto your principal, causing you to accrue even more interest over time.

Precomputed Interest

This type of interest is calculated up front and spread evenly across your payment. Paying this type of loan off early won’t save you any money on interest.

How to Save Money on Interest

Because interest is calculated based on the remaining principal balance, paying more than your minimum required payment can lower your total interest cost and help you pay off your loan faster.

Making extra principal-only payments can also help you save money long-term. Ask your lender if you can make principal-only payments to lower your balance and make sure you won’t be charged a penalty for making extra payments or paying off the loan early.

When you borrow money, it is important to understand what type of interest will be charged and how to calculate it. And if you are paying back a loan with a high interest rate, or one with compounding or capitalized interest, there may be options to refinance or restructure your terms to save you money. Call your local City banker, and we’ll be glad to take a look at your individual situation to see if we can help.