Have you ever wondered why banks offer different types of interest when applying for a loan? Let’s say you want to buy a house and use a loan to complete the purchase. Then, each bank tells you that you must give back a higher amount than you borrowed. The amount added to the original amount borrowed is the interest rate. But what exactly is an interest rate, and how can it affect your borrowing capabilities?
In this topic, we will discuss its definition, types, and how credit scoring systems affect your interest rates.
What is an Interest?
Interest is the cost of taking out a loan. It’s a fee assessed to the debtor or borrower for using a particular asset. These borrowed assets can be cash, goods, automobiles, or property.
Now, what is the definition of interest rate?
Generally, interest rates are the terms of payment agreed upon in a loan agreement. It applies to lending or borrowing transactions. People borrow money for various reasons, including making large purchases, starting or expanding businesses, and covering educational costs. On the other hand, businesses take out loans to invest in permanent assets like land, buildings, and machinery, as well as finance long-term expansion projects. You can repay a loan in a single lump sum by the due date, or you can make payments over time. Interest rates are the result of this process, and when they rise, it costs more to borrow the same amount of money.
What are the Different Types of Interests?
Interest rate levels influence credit supply and demand. The rate on each loan depends on interest rate factors such as credit risk, maturity, tax implications, and early repayment flexibility. That’s also why there are different kinds of interest rates.
To understand further, here are the various interest rate types applicable in the Philippines:
Fixed Interest
Fixed interest is the most common type of interest rate. This is an interest rate that remains the same throughout the entirety of the loan’s repayment period. They are simple to compute and understand, and they remain constant over the life of a loan or credit account, so all parties involved are clear on their financial commitments. This means that fixed interest rates don’t fluctuate with time, helping borrowers accurately estimate future payments.
Take this situation as an example:
Let’s say a borrower took a home loan from a bank for a total of P1,000,000 at a 10% interest rate for 10 years. This equates to an interest payment of P100,000 for the borrower. Due to the loan’s fixed interest rate and principal amount, the borrower will owe the bank a total of P1,100,000 at the end of ten years.
Variable Interest
Variable interest is the total opposite of fixed interest. This interest rate type fluctuates with time.
Lenders’ base interest rates, also known as prime interest rates, are closely monitored and used to calculate the amount of variable interest. With a variable interest rate loan, borrowers benefit if the prime interest rate drops, which often happens when the economy struggles. However, because this type of interest rate is linked to the prime interest rate, borrowers may be hit with higher payments if the prime rate increases.
The reason banks do this is to guard against an interest rate imbalance, in which the borrower pays less than the going rate for interest on a loan or credit. Borrowers, on the other hand, benefit as well. If they get a loan with a variable interest rate based on the prime rate, and the prime rate drops after they get the loan, they will not be overcharged.
Take the example of a P100,000 home loan with a 10% interest rate over 15 years that has received lender approval. The agreement specifies that the borrower will pay a fixed rate of 10% per year (or P10,000) for the first five years, with the interest rate assigned to the prime interest rate or base rate thereafter. Let’s say that after five years, the prime rate rises, causing the interest rate on loans to rise to 11%. As a result, the annual payment for the borrower is P11,000. However, if the prime rate were to drop and the borrowing rate was lowered to 9%, the annual payment would be reduced to P9,000.
Annual Percentage Rate
The annual percentage rate is widely used by credit card companies and credit card payment methods. In this case, the interest rate per year is determined by multiplying the total interest due by the cost of the loan as a whole.
Credit card companies use this kind of interest rate when cardholders make minimum monthly payments rather than paying off their balance in full. The prime interest rate is the basis for determining the annual percentage rate, with the margin charged by the bank or lender added on top.
For example, assume we have a credit card with a 24% annual percentage interest rate. That works out to a monthly rate of 2% for the full year. Because not all months have equal days, the annual percentage rate is divided by 365 days, or 0.065%, to calculate the daily percentage rate. Therefore, the interest rate is the product of the daily rate times the daily card balance times the number of days in the billing cycle.
Simple Interest
The simple interest rate is what banks commonly use to calculate the rate of interest they charge borrowers. Here’s how to determine this type of interest rate:
Simple Interest = Principal Rate X Interest Rate X Time
If you borrow P300,000 from a bank at 4% interest, and the loan agreement states that you must repay the principal plus interest at the end of the loan term, you will owe the bank a total of P312,000. This is assuming the term was a one-year lending agreement. However, if the loan has a term of 20 years, the interest payment will be:
Simple Interest = P300,000 X 4% X 20 = P240,000
Compound Interest
Some lenders favor charging interest on interest, which is known as compound interest. With compound interest, the sum of the principal and the accumulated interest from previous periods is subject to interest. At the end of the first year, the bank will calculate how much the borrower owes in principal and interest. The bank also figures that by the end of year two, the debtor will owe double the amount of the original loan (principal plus interest) plus the original interest (interest on interest).
The formula for determining compound interest is as follows:
Compound Interest = p X [(1 + interest rate)n − 1]
where:
p = principal
n = the number of periods for compounding
How Can Credit Scores Affect Your Interest Rates?
Whenever possible, you want to put your best foot forward when applying for loans. As a borrower, you also need to ensure your credit scores are high enough to get loan approval.
In most cases, a higher credit score means better loan terms, interest rate types, and conditions. You have a better chance of being approved, and if you are, you may be eligible for a lower rate and save thousands in interest over the life of the loan. So, if your credit score is low, chances are you will receive higher interest rates or won’t be approved at all.
That’s the way it works at banks, too. Banks need to make sure the borrower has a trustworthy credit score before they allow them to take out a loan. The legitimacy of your application is examined as part of the screening process. Banks can use fraud detection analytics to check the legitimacy of a loan application. They can verify if the applicant in question is indeed real, has past undisclosed debts, or has engaged in any other fraudulent activity. In this way, they can protect their assets and prevent any illegal activity from happening.
Understand the Types of Interest Before Taking Out Loans
Interest rates have a significant impact on everyone. They are the price you pay to borrow money, and their effects extend far beyond the size of your monthly payment or the total amount you pay back. In addition, borrowers are better able to make sound financial decisions when they have a firm grasp of the various types of interest rates. If you need more information on interest rates, feel free to reach out to us, and we will gladly assist you.
