Understanding Interest Rates: How to Calculate the Cost of Credit - Blog

Understanding Interest Rates: How to Calculate the Cost of Credit

The average American pays over $6,000 in interest rate payments a year. With this number seemingly increasing, we need a better understanding of how interest rates work. 

But where to start? What even are interest rates and can I calculate them to lower my costs?

That’s what we’ll be looking at today. Interest rates play a crucial role in your debt. Read on to find out about understanding interest rates here.  

What are Interest Rates?

Car loan application with car keys - Prudent Financial SolutionsWhen you make a loan to someone, the interest rate is the amount you’ll have to pay as a percentage of the principal. In other words, it’s an additional cost you’ll have to make on top of the initial payment. 

Think of it like a rental or leasing charge given to you for using an asset. The amount someone charges as interest can change based on the borrower.

For example, someone with a good credit score and is known to be reliable with payments might get a lower interest rate compared to someone who’s always in debt. 

As such, a good credit score and solid credit history are crucial to maintain if you want lower interest rates. 

How Interest Rates Play Into Your Debts

When we talk about the impact of interest rates, we can boil it down to two main types. 

The first is through installment loan interest rates. In these cases, the interest payments are built into the loan payoff. 

In other words, you’ll be paying the interest rates at the same time you’re paying off the principal. If you borrow money to purchase a car, you’ll be paying the monthly payment on top of the interest to your lender. 

Credit card interest is the second category and it works quite differently.

A credit card is categorized as a line of credit. The issuer charges you interest as a finance charge. This charge is added to your balance each month until you pay it in full.

The main difference between the two is how one is more of a required monthly payment while the other is largely avoidable. The impact of interest rates depends on your ability to pay each pay period. 

Understanding Interest Rates: How to Calculate

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If you’re trying to calculate the best interest rate or want a ballpark of your monthly payments, you need to know the interest rate formula. 

The most basic version is the simple interest rate formula. This is determined by multiplying the interest rate by the principle and the number of days between payments:

Simple Interest = Principle x Interest x Number of days between payments

Say you took out a $4,000 student loan with an interest rate of 4%. If you pay the loan over the course of 4 years, the equation would be:

4,000 x .04 x 4 = $640

The amount of simple interest paid would be $640. Add this to your total loan payment and you have a total of $4,640. 

Take Control of Your Interest Rates Today

Understanding interest rates can be hard since you have to contend with a lot of percentages. Use this guide to help you get a better grip on interest rates and start saving today. 

Need help consolidating your debt? Contact Prudent Financial Solutions and we can get you started ASAP. 

April 28, 2021
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Understanding Interest Rates: How to Calculate the Cost of Credit

The average American pays over $6,000 in interest rate payments a year. With this number seemingly increasing, we need a better understanding of how interest rates […]