Regardless of whether you are looking for a loan for the first time, or if you take out loans (such as using credit cards)frequently, it is important that you know about your interest rates.
This is because there are various types of interest rates and often times a normal person can easily get confused as to how the different rates and terms can be affecting their wallet. This article focuses on the different types of interest rates in order to help you get a better understanding of them.
Simple Interest Rate
Like its name implies, this type of interest rate is quite simple and basic. Because of that fact, it is also easier to calculate as compared to other types. A simple interest rate is calculated based upon the principal amount which is not paid yet. Additionally it is not charged on daily basis but rather for a whole year or term of the loan. This keeps the budget consistent and helps to pay the debt easily. For instance if you have borrowed $1000 and simple rate of interest is 6.5% for one year then the interest paid will be $65.
Compound Interest Rate
This type of interest rate is almost opposite to the simple interest rate. A compound interest rate is calculated on a periodic basis. Most types of loans and accounts operate on compound interest. Credit cards are one of the most common uses of compound interest we face in our lives daily. The good part is that most credit cards do not begin charging interest during the first month, so if you are someone who pays and clears the full balance on credit cards every month then you likely won’t be charged interest. With compound interest, it is important to make more than the minimum payment each month on your loans. By paying just the minimum, most of your money goes towards interest and in the end the principal amount doesn’t reduce by very much.
Annual Percentage Yield
Also known as the APY, the annual percentage yield is a way to calculate an interest rate as it is compounded throughout the year. An APY is usually in reference to money that you are earning, such as on a savings account or an investment. Your interest rate is the percentage of your base investment which is earned over a year but, thanks to compound interest, many banks or creditors calculate it on monthly basis. Let’s say your bank pays you 3% of interest on your savings account with amount deposited of $1000. You’ll actually end up getting slightly more than what you initially think you’re entitled to thanks the compounding interest.
This is because the bank would divide the 3% rate over 12 month’s period to calculate it monthly and the monthly rate would be 0.25%. So you’ll get $2.5 in interest during the first period (0.25% x $1000) which will make the total amount $1002.5. The next period, the rate of 0.25% will be calculated on $1002.5. In this situation, you would earn an extra $0.42 on your deposit. While your interest rate is 3.00%, the APY would be 3.04%. While here the gains may be minor, with more money, time and higher interest rates the bonus can be quite significant.
Amortized Interest Rate
This kind of interest rate is frequently used in case of car loans and mortgages. It is designed in such a manner that when you make a payment every month, you’ll pay an interest payment and some amount of the principal will be also reduced. Every payment you make results in a lesser principal amount being owed on the loan. If you take out a car loan for five years, the interest you would over the entire period is calculated at the beginning and split, along with the principal, over five years’ worth of payments.
These are four of the most commonly used terms to describe interest rates and they are not too complex or difficult to understand with just a little research. By understanding the terminology, you’ll ensure you get the best deal possible on your loans.