How Does Interest Work on Personal Loans?

by ETF Base on July 2, 2014

The way that companies make a profit on a loan is to charge interest on it. This money, which is charged with every payment along with a portion of the interest, is utilized as both profit and as a mechanism to help increase the amount of funds the company has to lend out to others. Here is how interest works.

There are many great online tools that will help you calculate the loan amount.  Many of these will have a breakdown of the payments and how much interest you typically pay each payment.

Amount of Principal

Say for instance you have a principal balance of a thousand dollars on a credit card and a yearly interest rate of six percent. Since you pay monthly, the interest is calculated monthly. Since this is a revolving line of credit, assuming you have an agreement with the company to retire any debt in eighteen months.

The interest would work out to this equation: The principal is multiplied by the interest, with the interest being divided by the number of calculating instances per year. In other words: Principal X (Interest/12) It would look like this when typed out in a calculator: 1000*(.06/12), and the final answer would be five dollars.

This is combined with the principal payment of 1000/18, or $55.56, to total a bill of $50.56.

Interest Rates

If you do not add any new principal to the account, the following month you will have 1/18th less to be charged interest on. This means you will save twenty seven cents in interest.

Another note is that interest rates vary greatly by the loan type. Getting a loan from a quick cash company will have a higher interest rate than a traditional loan.

Paying More in Principal

If you pay an additional fifty dollars that first month, for a total bill of $105, then the interest for the next month (assuming the credit card company still has you on track to retire the debt in eighteen months) would be $4.50. This is an additional twenty-three cents you would be saving. Over time, this adds up to a decent amount, and if the loan amount was larger you would be seeing even more dramatic changes.

Interest is one of the few things you cannot escape in the modern world. Everywhere you go, you will encounter items that cost too much to pay for all at once, and thus have to turn to credit. But, by having a good idea on how interest works, you can figure out how much the item will truly cost and thus find the best deal possible.

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