At some point or another, when you go about applying for a loan, you’ll probably hear about something called an interest rate.
If your initial reaction is one of utter confusion, don’t worry; you’re not alone.
Stick with us—we’ll get you through this.
Simply put, here is the definition of interest rate:
Interest rate is the amount a lender charges a borrower in return for giving them a loan.
It is expressed as a percentage of the principal (e.g., 15.9%), usually, in annual terms.
It is applied as either a fixed rate (where it remains constant throughout the life of the loan) or a variable rate (where it fluctuates depending on underlying benchmark rates).
Typically, every type of loan—whether home, car or personal—will charge an interest rate. That rate will vary depending on the type of loan, the lender, and factors such as the borrower’s credit score.
The interest rate is crucial because it is a primary factor in determining how much a loan will cost you over time.
All other things equal, the lower the interest rate, the less interest you’ll pay for the loan in the long run, so typically it’s a good idea to seek out the lowest interest rate.
Your wallet will thank you.
When paying off a loan, you’ll typically be required to make monthly payments. The total amount of each payment will include repayment of a portion of the outstanding balance on the loan and the amount of any interest that is due.
Keep in mind that the interest rate is generally expressed as an annual rate, even though your payments will typically be made in monthly installments.
The interest rate applies to the outstanding balance of the loan. For example, if you take out a $10,000 loan with an interest rate of 15%, the initial amount of interest you will owe will be 15% of the entire $10,000. But down the road, assuming you pay down the outstanding loan amount, you’ll only pay interest on the remaining amount you still owe.
(NOTE: For fixed-rate loans, your monthly payment typically does not change, but at the start of your loan term, more of that payment goes toward paying interest, while at the end, more goes toward the principal.)
If you want to reduce the amount of interest you pay on your loan, do what you can to polish up your credit score before applying so you could potentially snag yourself a lower rate.