It seems that everything is very simple: there is a loan and there is an interest that you need to pay for it. But the magic of simplicity disappears when a loan calculator suddenly reports that for $2,000 borrowed at 10% annual interest rate you need to pay more than $2,000. We will try to explain why this happens.
What is a loan annual interest?
In simple words, the loan interest is the value of money. A bank is an organization that treats money as a commodity; it gives them to borrowers for temporary use and charges a fee. This is how to rent a car – you took it, took a ride, returned it, paid for the time.
When it comes to a personal loan or a mortgage, they set the ANNUAL percentage because it is easier both for the client and the bank. By the way, pay attention to the word “annual” – if it is not mentioned in the loan agreement and the loan comes with a suspiciously low interest, perhaps this refers to quarterly or even monthly interest. Large banks will not deal with such dubious things, but microfinance organizations or little-known banks can do it.
What determines the size of the interest rate?
The most important regulator is the minimum country rate set by the central bank. No one will issue loans below this threshold.
The second most important parameter is inflation. Inflation is when money gets cheaper. Inflation is strongly tied to emissions (issuing banknotes into circulation by the government), but we won’t get into these wilds. The bank is interested in making a profit for the amount that it expects when issuing a loan. But in a year, money will cost a little less (you can buy less for the same amount), so you need to raise the initial interest rate to the real / estimated inflation rate.
And finally, the premium / additional payments. There is one caveat – it will be difficult for banks, especially small ones, to make money if the price of ordinary loans will consist only of the refinancing rate and inflation. Banks run the risk of non-payment, banks actively take loans from each other and from the Central Bank, banks need to pay offices and salaries… Therefore, they use tools to increase the final cost – from a banal allowance to raising rates for certain categories of customers. By the way, the larger the financial institution, the lower the premium.
What does overpayment depend on?
It depends on interest and type of payments. There are 2 type of payments:
- Annuity. The interest on the loan is calculated in advance, the payment schedule is calculated so that you pay a fixed amount each month, but in the first months you mainly pay off the interest, in the last months – the main debt;
- Differentiated. In this case, they take your main debt, distribute it in equal shares throughout the term, and interest accrues on the outstanding amount.
In theory, differentiated payments are more advantageous than annuity payments. In practice, loans with such payments have a higher rate, so the overpayment is approximately the same.
Types of interest rates
There are many types of interest rates, but they are not so important for lending to individuals. We list briefly:
- Fixed / floating. In the first case, the rate remains unchanged for the entire period, in the second case it changes;
- Fcursive / antisipative. In the first case, everything needs to be paid at the end of the term (microfinance organizations), in the second – in advance or in the process (banks);
- Nominal / real. Excluding inflation or adjusted for inflation.
What is the effective interest rate and how to calculate it?
Usually the question “What does the loan percentage mean?” arises due to the fact that the percentage indicated in the proposal does not converge with the interconnection. And here comes the effective interest rate. Effective interest rate is the interest on the loan plus all additional payments and fees. For example, the bank’s website says: “We offer a loan at 8.5% per annum.” It already looks strange – the price covers the refinancing rate but does not cover inflation. We open the documentation, and we see that “if you are not a payroll client, then you get + 0.5%; if you live in New York, then you get + 1%; if you take less than $5,000, then you get + 1,5%.” The situation becomes clearer – a loan will cost you 11.5%. Besides, it turns out that the money is given on the bank card, and the commission for withdrawing it is 1.2%. In this case, the loan is provided in cash. It turns out that the real rate is 12.7%. This is the effective interest rate.
How to calculate it? You gather all the documents on the loan and carefully study them for promotions, additional conditions, services and commissions. These documents can be found in the public domain on the bank’s website, but there is a problem – usually the information on additional expenses is “scattered” on different documents, so please be patient.
How to affect the percentage of annual loan?
You cannot influence the initial price; it is set by the bank. The only option is not to increase this percentage. Pay on time, search for special offers, look for benefits, read and study documents. In extreme cases (if you really need to reduce this percentage), restructuring and refinancing are available to you – this will help lower the interest rate but increase the duration of the loan.