Loan interest: what is it
In essence, interest is a payment for a loan. For example, you take out a loan for $20,000 and have to pay back $23,000. That $3,000 is the interest you pay over the life of the money.
The monthly payment can be conditionally divided into two parts. One is used to repay the loan itself, and the other is to pay interest. The amount of interest depends on your income level, loan amount, credit history, and other factors.
Simple interest
In this case, you have a fixed payment. The rate depends on the loan amount that remains to be paid. In this case, early repayment makes some sense. If you return the funds earlier, you can save a good amount on interest.
Amortization of the loan
Most lenders use an amortization schedule. These are student loans and money for a car. The number of payments remains unchanged. But the creditor changes the allocation of funds every time.
Initially, most of the payments go to paying interest. Closer to the end of the loan term, the principal amount will go to pay off the debt.
Peculiarities of interest calculation
Lenders use different approaches to calculate the amount of interest. It isn't easy to do it yourself. So let's figure it out together.
Simple interest
In this lending option, the formula is used: the loan amount multiplied by the interest rate multiplied by the lending term. As a result, we will get the total amount of interest.
If you borrow $20,000 for five years at 5 percent, it would look like $20,000 × 0.05 × 5 = $5,000. The amount of interest will be $5,000.
Amortized loan
The calculation of interest on an amortized schedule is entirely different. You need:
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divide the rate by the number of payments in the current year;
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the received number must be multiplied by the loan balance (you will receive the amount of interest that will be charged in the current month);
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the amount of interest must be deducted from the amount of the payment (this amount of money will go to repay the loan).
To determine the interest amount for the next month, you need to repeat the procedure.
The schedule is often quite dynamic. In this case, you should use a special calculator. In this way, you will quickly see which amount goes to interest payments and which amount goes to repaying the loan.
What affects the amount of interest?
It is difficult to say immediately what the interest rate will be. Several main factors are taken into account for the calculation.
Loan amount
The loan size affects how much money will have to return to the lender. The more you borrow, the more the interest will be. A large amount of money is always a risk. Therefore, the creditor seeks to insure.
Don't take more money than you need. Before applying for a loan, you should compare all the numbers and decide on the amount.
Credit term
The term of the loan is the time for which funds are provided to you. In some cases, short periods make it possible to settle the debt faster. But consider that it will assign large payments, but with low interest.
When taking out a long loan, it may seem that the charges are smaller. But it is worth considering that the loan stretches over many years. Therefore, you may overpay a significant amount.
It would help if you chose the loan term based on the amount you are willing to spend on repayment. Choose options that fit your budget.
Payment schedule
Usually, payments for debt repayment must be made every month. But if you can pay the extra amount, it will help you save on interest. In this case, it is essential to ask the creditor whether the additional payment will be used to pay off the body of the loan.
You should make additional payments if you want to save on interest payments. It will reduce the loan amount. Accordingly, the interest will be lower.
Total repayment amount
The repayment amount is the amount you pay each month. As you already know, the payment divides into interest payments and loan payments. It makes sense to contribute a little more money. It will help pay off debts faster.
But before that, you should talk to the creditor. The overpayment must go to pay off the debt. Only in this case will it be possible to save money.
Conclusions
Before taking out a loan, you should calculate the interest amount. This way, you can decide on the terms of the loan and its size. It is also worth asking how interest is calculated. It will help to choose the best option for early repayment of the loan.
