Interest might seem simple, but don’t be fooled.
You may have seen the term APR before. But what is it? Is a lower number better? APR stands for Annual Percentage Rate. It’s the cost of borrowing money, expressed as a percentage. When you take out a loan or use a credit card, the APR represents the interest rate you’ll pay on the outstanding balance.
Typically speaking, the higher the APR, the more interest you’ll pay over the life of the loan, but it’s not always that straightforward. To calculate your monthly payments, you’ll need to know the principal amount, percentage rate and repayment term, and any additional charges the loan has.
So, if you have a credit card, it may have an APR of 18 percent, meaning you’ll pay 18 percent interest on your outstanding balance annually. If you carry a balance of $1,000, you’ll pay $180 in interest over a year.
But, if you have a personal loan of $1,000 with an APR of seven percent over a five-year term, you’d actually pay more interest. This is because you’d pay seven percent annually ($70), but over the five years, you’d pay $350 in interest in total, nearly double the amount you’d pay on the 18 percent credit card. Or would you?
Well, maybe not. The interest may be worked out each year, so in year two, you may owe seven percent interest on just $800, because you’ve already paid the first $200 of the loan. Therefore, you’d pay $64 interest in year two, versus $70 in year one, and this amount will reduce over the course of the loan. In this example, you’d end up paying a total of $218 in interest, representing 21.8 percent of the loan’s value. This is why it’s important to check with your loan or credit card provider and ask exactly how they work out the interest owed.
Even though the APR on two loans could be the same, the total interest paid can vary based on the loan term. With a longer loan term, you’ll spread out the principal repayment over more months. This is likely to reduce your monthly payments, but you’ll end up paying more in interest over the life of the loan.
It’s worth noting that interest may be worked out monthly. If you have $1,000 on a credit card at 30 percent APR, that is $300 of interest annually. However, on your bill, that is likely to look like $25. If you cleared the whole balance in month two, $1,000 could cost you just $25 in interest, despite the 30 percent APR.
While a lower APR generally leads to lower interest payments, it’s important to consider both the APR and the repayment term when comparing products.