Saturday, 6 July 2019

Interest on Loans - How Does It Work

Interest on Loans - How Does It Work

I want to talk about something that it's huge when personal finance and we're talking about interest. What is it, how does it work, is it good, is it bad honestly but it doesn't mean that it's confusing, but I really want to make sure that everyone understands how interest work because it is a very big factor when it comes to personal finance.

I'm going to break this article in 2 parts, how is it good for you, how is it bad for you. I don't know how you like to take your news but I've got good news and bad news, I normally take the bad news first, so we're going to start there.

  • When most people hear the term interest it's normally because they're talking about a loan. What is the interest rate on loan your credit card, your car loan, your mortgage

  • All these are a loan from a bank and they all have an interest rate attached to them when you take out a loan from a bank or credit union they want you to pay off the original amount that you borrowed 

Let's say you borrowed $10,000 buy a car they want you to pay that $10,000 back plus interest which is extra money that goes to the bank. That's how they make their money on loans through interest.

How much interest you pay them is entirely based on your rate, so when you're taking out a loan you want to make sure that your interest is as low as possible. Because if you do this it means you're going to give less money to the bank in the form of interest and save you money

  • When it comes to loans it's really simple, you want a low-interest rate, the lower the rate, the less you pay.

What we're going to do is we're going to make a little scenario here, we're going to pretend someone is buying a car.


How Interest on Loan Work

I don't quite want to show you how to calculate interest just yet, I will in another article, but for today's purposes just understand that I've already done the math for this and I know how it works out but in this example 

  • Car Loan: $10,000
  • Term Lenght: 3 years
  • Interest Rate: 2%
  • Loan Interest: $311.59
  • Loan amount ($10,000) + interest ($311.59) =
  • Total Loan Cost: $10,311.59

  • This person wants to buy a car for $10,000
  • They want to pay the car off in 3 years
  • They find a good credit union or banks that give them 2%
  • This person will pay the bank $311.59 in interest
  • That means when he takes the original $10,000 that he borrowed plus his interest over those 3 years, he paid a total of $10,311.59

This truthfully would be considered a pretty good loan.

Now, let's take a look at what would happen if that person didn't decide to do their homework or research or they just went to the bad bank.

That same person let's say they did a $10,000, 3 years, kept those 2 factors exactly the same, but let changes it, they didn't get 2%, they got 10%

  • New Rate: 10%
  • That comes out to $1617.60
  • Principle + Interest + $11,617.60

That's a difference of $1306.01, I don't know about you but I do not want to pay the bank an extra $1,300 if I don't have to. 

This is just one example and honestly, it's kind of a small one, when you're talking about a house or more expensive car, the difference can be tens of thousands of dollars

That was just to illustrate how interest is really important when it comes to loan and why you need to do your research to make sure that you were getting a low-interest rate on your loans.

Now, I'm not going to lie to you what largely determines the interest rate you get on your loan is going to be your credit score.

Alright, we got the bad news out of the way now, how interest rate affects some loans and how it hurts us, now, we can go on to the good part and see how it intersects benefits us.

We have talked about how interest loan hurts us because interest on a loan can be bad but now we're going to talk about how interest can help us and that is banks will actually pay us interest.

  • Many of you probably already know that but for those of you that don't. Banks pay us interest and what is called

Dividends: Interest that banks pay us

This works out almost the exact opposite of loans, because when it comes to dividends we want our interest rate to be as high as possible, the higher the dividend rate or the interest rate, we make more money.

The lower the dividend rate or interest rate the less money that we make. 

We are going to continue on our next article, do watch out for that.

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