Borrowers are all aware that the cost of a loan is determined by the amount borrowed, the interest rate, and the repayment period, and they are aware of the difference between nominal and effective rates. But how do you calculate the interest rate on a loan? How does this work?
Fixed rates and variable rates
Borrowers looking to purchase a home can choose between fixed-rate and variable-rate mortgages. While the first option allows you to plan your expenses over time and provides some peace of mind, the second requires a high level of risk tolerance but usually allows you to save money in the long run. There are also loans with annual interest rates that require a slight tolerance for fluctuations: these are protected variable or “capped” rates.
Posted rates and real rates
All loans have a nominal rate (also known as the annual contractual rate), but they cost more because they use the compound interest method, which is similar to a variable interest rate:
- Semi-annually for mortgages
- Monthly or even daily for other types of loans.
- This has the effect of inflating the effective rate.
Take a Look at This Example…
A nominal annual rate of 3% on a semi-annually compounded mortgage is equivalent to an effective annual rate of 3.0225% when using the simple interest formula below:
Real annual percentage rate = (1 + rate X time) – 1.
And, because the more frequently the nominal rate is compounded, the higher the cost of borrowing becomes, an example with a short-term loan is even more striking: a nominal rate of 24% becomes an effective rate of 26.82% when compounded monthly, and 27.11% when compounded daily.
The principle of amortization
Loans, with the exception of payday loans, are subject to an amortization schedule calculated based on:
- The original loan amount borrowed
- The repayment schedule (long-term loans or shorter loan terms)
- The frequency of payment (can be higher for larger loans)
- The interest rate (higher for unsecured loans for example)
When a borrower makes a payment on an amortized loan, a portion of the capital and interest are repaid. And, as the funds are paid back and the amount borrowed is reduced, the portion of each payment allocated to interest decreases from previous periods, while the portion allocated to capital increases.
A loan calculation example
A borrower repaying a $5,000 debt at a 15% interest rate over 48 months will pay $139.15 per month.
Their first monthly payment will be $76.65 of principal (or capital repayment) and $62.50 of interest, while their final monthly payment will be $137.44 of principal and $1.72 of interest. The borrower will have paid a total of $6,679.38, of which $1,679.38 is interest.
A low rate can be deceptive
We are sometimes enticed by low-interest loans, believing that we are paying very little interest. The cost of a loan, on the other hand, is determined by the amount borrowed as well as the amortization period. A $10,000 debt amortized over 72 months still costs $1,578.43 in interest, plus late payment penalties and inflation.
Low Interest Rates are Not Always the Best Option
Loan interest rates are presented as attractive, which highlights the importance of understanding the difference between the nominal rate and the effective rate of return and running a simulation with the amortization schedule to determine the interest to be paid and what monthly income ratio you can use before deciding to apply for an online loan.
You have to be aware with debt accumulation
Even with no refusal loans, if the borrower does not repay his credit on time, it may have a negative impact on his credit score and leave a mark on his credit history. Furthermore, taking out a new loan may be risky if he already has a current debt to repay. Taking money from your savings to repay your debts, on the other hand, could wreck your economy and put you in a bad financial situation.