What Is An Interest Rate? Interest Rates for Personal Loans, Explained

What Is Interest Rate? Definition & Explanation

Susan Guillory

Updated January 18, 2022

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If you’re looking into personal loans for the first time, you may wonder how interest rates work and what a particular “APR” actually means in dollars and cents.For starters, the definition of interest rate is the percentage of principal (amount of money loaned) that is charged by the lender for the use of its money. Lenders take different approaches when it comes to charging interest. Some charge simple interest, while others charge compound interest, which can make a major difference in how much interest you’ll pay over the life of the loan.It’s important to be informed as a potential borrower so you know what you’re getting into when you take out a loan and also so you can compare personal loan rates. Read on for a quickie guide to understanding interest rates.

Interest Rate Definition

The interest rate is essentially the fee the lender charges a borrower, and this fee is calculated as a percentage of the amount you borrow.Interest rate is also what the bank pays you in return for making a deposit (which they use to fund loans). This interest rate is calculated as a percentage of the amount deposited or put into a savings account.Banks generally charge borrowers a slightly higher interest rate than they pay depositors. The difference is their profit. Since banks compete with each other for both depositors and borrowers, interest rates tend to stay within a narrow range of each other.

How Interest Rates Work

Interest rates on consumer loans are typically quoted as the annual percentage rate (APR). The interest rate is applied to the total unpaid portion of your loan. This interest will accumulate over the duration of the loan, which might be several years. Although interest rates are typically competitive, they aren't the same for every borrower. When the borrower is considered to be low risk by the lender, the borrower will usually be charged a lower interest rate. If the borrower is considered high risk, the interest rate that they are charged will often be higher, which results in a higher cost loan.

Types of Interest Rates

There are two primary ways to calculate interest.

Simple Interest Rate

The simple interest rate is, as the name implies, simple to calculate. It’s derived by multiplying principal by the interest and then by the loan term, or…principal x interest rate x time = simple interestHere’s an example. Let’s say you want to borrow $10,000 and will repay it at 5% interest over five years:$10,000 x 5% x 5 years = $2,500If the lender charges a simple interest rate, the total amount of interest you would pay on a $10,000, five-year loan would be $2,500. Dividing this over the five-year period, you’d pay $500 a year in interest. If you pay off the loan early, you would pay less in interest.

Compound Interest Rate

But not every lender uses the simple interest formula. Some lenders prefer the compound interest method, which means that the borrower pays even more in interest. Compound interest is essentially interest on interest. The interest is not only applied to the principal but also to the accumulated interest of previous periods. At the end of the first year of the loan, the bank assumes the borrower owes the principal plus interest for that year. It also assumes that at the end of the second year, the borrower owes the principal plus the interest for the first year plus interest on the interest for the first year.The formula for figuring out compound interest (in which interest compounds annually) is more complicated and looks like this:P x [(1 + interest rate)ⁿ – P]“P” stands for the principal and “n” stands for the number of compounding periods. Using the same loan/principal amount as above ($10,000) and same interest rate (5%) and length of loan (5 years), here’s how you would calculate compound interest:10,000 x [(1 + 5%)⁵ - 10,000] = $2,762.82With compound interest, you’d pay $2,762.82 on a $10,000 loan over five years, or about $553 per year. You can see why you need to know what type of interest the lender charges so you know if you’re paying more or less.For shorter time frames, the calculation of interest will be similar for simple and compound interest methods. As the lending time increases, however, the disparity between the two types of interest calculations also increases.

How Interest Rates Are Determined

The interest range charged by banks on loans is based on several factors. The primary one is the interest rate set by the central bank of the U.S., which is the Federal Reserve. The Federal Reserve interest rate is what banks charge each other for overnight loans.If the Federal Reserve sets interest rates at a high level, the cost of debt rises. When the cost of debt is high, it discourages people from borrowing and slows consumer demand. When the Federal Reserve sets a low interest rate, borrowers will typically have access to loans at inexpensive rates. As a result, they are more likely to borrow and spend. While governments generally prefer lower interest rates, they can lead to a situation where demand outpaces supply, which leads to inflation (rising prices).In addition to the interest rate set by the Federal Reserve, lenders will use other factors to set their interest rates on loans, including your credit profile. If you have great credit, you’ll likely qualify for lower interest, but if your credit is poor, you may pay more in interest to get a loan.Recommended: Credit Scores: What’s Involved in Calculating and Improving Your Credit

Interest Rates on Personal Loans

There are interest rates on many financial products, from savings accounts (where you earn interest) to home mortgages and personal loans (where you pay interest). If you’re considering taking out a personal loan, the rate you pay will depend, in part, on whether it’s a long-term personal loan or a short-term loan, as well as what kind of lender you borrow from.Interest rates can vary from one lender to another. So, it can be wise to research average interest rates so you know where the rate you’re offered lands on the spectrum and can shop for the best deal for your financing needs.

Factors That May Affect Personal Loan Interest Rates

Lenders don’t only consider the federal interest rate when determining the interest rate for a loan. They also consider the following factors:

Credit Score

Generally, the higher your credit score, the better the interest rate you qualify for. If your credit is poor or you haven’t yet established your credit profile (maybe you’re fresh out of college and haven’t even had a credit card to help build it), you may want to work on building or improving your credit before taking out a loan.

Loan Principal Amount

How much you borrow can also influence what you pay in interest. The more you borrow, the greater the risk to the lender that you won’t be able to pay all the money back, so some lenders may charge more for higher loan amounts than they do for small personal loans.

Repayment Term

It can be tempting to take the longest repayment terms possible because your monthly payment is lower. However, you’ll often pay more in interest over the entire period. Shorter loan periods often come with lower interest, though they will have higher monthly payments. If you can afford to pay more each month, you’ll likely pay less in interest overall.

Lenders

While lenders generally stay within a range of interest rates to remain competitive in the financing space, each has its own secret sauce when it comes to what they charge in interest. The key is finding the lender that has the best terms for you.In some cases, you can prequalify with a given lender to see what rate you could get without a hard inquiry on your credit. This allows you to check with a few different lenders in order to find the best rate and terms.

The Takeaway

When you take out a loan, the lender wants it to be profitable, and so it charges you interest, which is for the privilege of borrowing money. Interest is typically calculated as a percentage of the principal, or total loan amount. How much loan interest the lender charges is determined by a variety of factors, including the interest rate set by the Federal Reserve, your credit history, loan amount, and loan terms.As you shop around for loans, it’s important to find out not only what the interest rate will be, but also if the lender is charging simple interest or compound interest. A simple interest loan will typically cost less — especially if you pay it back early.If you’re interested in quickly comparing rates on personal loans, Lantern by Sofi can help. With our online lending platform, you can get multiple offers from personal loan lenders with just one application.

Photo credit: iStock/ThitareeSarmkasatThe tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC112234

About the Author

Susan Guillory

Susan Guillory is the President of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.

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