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How Does Interest Work on a Loan?

Money lending is a business that has been around for thousands of years and worked on the same principle ever since. Every time you take out a loan, you’ll need to pay back the lender with interest. This is how the lender makes a profit.

To help make the idea of ‘interest’ a little less daunting, here are the basics you should know when considering a loan agreement.

What is interest?

Interest is basically the cost of borrowing money. When you take out a loan, you’ll have to repay both the money you borrowed in addition to a set amount of interest.

The amount of interest you pay is typically expressed as a percentage, referred to as the interest rate. This rate defines the portion of the loan that you’ll need to repay. You’ll typically find that your interest will be quoted as a yearly rate. However, it can also be calculated for shorter or longer borrowing periods.

Types of interest

There are two main types of interest, simple and compound. Simple interest is based on the principal amount only (the amount you borrowed). Compound interest is calculated using both the principal amount, as well as any previously accumulated interest – essentially meaning that you’ll need to pay interest on the interest.

For example, if a loan for $5,000 is taken out for two years, with a simple interest of 10% per year, the total amount you’ll end up paying back is $6000. 10% of $5000 is $500, and over two years that’s an extra $1000 on top of your original loan.

If the same amount of money were borrowed with a compound interest of 10% per year, the amount of interest you’ll pay over the two years would be a larger total of $6050. This is because in the second year, you’re paying interest on the original amount borrowed + the interest of the first year. So that’s 10% of $5000 in the first year ($500) plus 10% of $5500 in the second year ($550). Compound interest continually charges additional interest on the balance owing, making it more expensive. This is a basic explanation, but hopefully outlines the major difference between the two types of interest. You can see how compound interest can quickly add up.

Keeping this in mind, it’s essential to consider if a loan uses simple or compound interest when making your decision.

How much interest will I pay?

The amount of interest you’ll pay often depends on how ‘risky’ the lender considers the loan to be. Usually if you’re asking to borrow a large sum of money, the interest rate will be higher as there is a larger risk of you not being able to pay it back.

At QuickCash, our interest rates are set according to the Loan to Value Ratio (LVR), which considers the amount you’re borrowing and the security you have available. Depending on your LVR, the rate will then typically vary between 12.5% and 26%, but this may differ for each applicant.

interest rates increasing on a graph

What is a Loan to Value Ratio?

A Loan to Value Ratio (LVR) refers to the amount (often expressed as a percentage) that the lender believes you need to borrow to buy a particular asset.

For example, if you want to buy a house that the lender values at $400,000, in which you have a $90,000 deposit. To purchase the home, you’ll need to borrow $310,000. Your LVR would then be calculated by dividing $310,000 ÷ 400,000= 77.5%.

Generally, an LVR below 80% shows the lender you’re not entirely relying on them to make your purchase, which lowers the risk of the loan. If your LVR, was, however, over 80%, some lenders may see this as being too risky and deny the loan.

How can I get a lower interest rate?

In addition to considering how much you want to borrow, your LVR takes into account the security you have available. This security refers to an asset (e.g. a car, motorbike, piece of real estate, etc.) that you can put up against your loan. In the instance that you can’t repay the lender, they’ll take ownership of the asset and sell it to recover the money owed. As a secured loan is a smaller risk for the lender, this generally means that you can borrow higher amounts at a lower interest rate. At QuickCash, our secured loans mean you can borrow higher quantities of money at a lower interest rate.

Likewise, your credit rating can also influence your interest rate. This rating is essentially a score that uses your credit history to estimate if you’ll be able to pay back the money you’re borrowing. Generally, the higher the score, the lower the interest rate. You can check your credit score, without lowering it by using online tools such as Credit Simple.

When you apply for a loan from QuickCash, information from your credit rating will be used to evaluate your application. Don’t stress if you don’t have a high score as we still might be able to approve your loan depending on how much you want to borrow and what security you have.

When do I have to pay the interest on my loan?

The length of your loan will also impact the amount of interest you pay. While shorter loans generally have higher repayments, they usually have less interest in the long run. Alternatively, if you have lower payments spread out over an extended period, you’ll end up paying more in interest.

The way that you pay back your loan is often referred to as a repayment schedule. This schedule may differ depending on whether your loan is an instalment or a revolving loan.

An instalment loan, such as a mortgage or car loan, must be paid back in steady payments each month. The amount you pay is established when your loan is first approved and remains fixed over the borrowing period. On the other hand, a revolving loan, such as a credit card, isn’t issued as a predetermined amount. Although there’ll sometimes be a minimum monthly repayment required, your outstanding balance does not have to be repaid within a specific time frame.

What type of loan has the lowest interest rate?

There’s no way to avoid the fact that borrowing money costs money, but it doesn’t have to be a considerable expense. In comparison to many other types of high-interest loans, personal loans such as car loans and holiday loans, typically have the lowest interest rate.

We hope that this has helped you feel more knowledgeable about paying interest on your loan. If you want to apply for a loan, contact us today.

If you have any questions about this article, or about personal loans in general, feel free to call us on 0800 784 252.

Disclaimer: This article is intended to provide general information only. It does not take into account your financial needs or personal circumstances. It is not intended to be viewed as investment or financial advice. Should you require financial advice you should always speak to an Authorised Financial Adviser.