taking notes on a book about loans

What are Interest Rates and How Do They Work?

March 20, 2023

Learn about interest rates and annual percentage rates so you can weigh your different loan options and make smart loan decisions.

When taking out a loan there are many loan terms to remember to help you understand your loan and loan agreement. One of those terms is the interest rate. You might also hear the term Annual Percentage Rate or APR when referencing your loan’s interest rate. 

What Does Interest Mean?

interest rate definition

Whenever you’re taking out a loan or a credit card, you’ll hear the term “interest rate.” In the financial sense, interest is the word used for the payment a borrower makes to the lender for a loan. When borrowing money, the lender needs to make some kind of profit in order to stay in business. Lenders make a profit from giving loans by getting paid more than the amount of the loan borrowed. One of the main loan payments comes in the form of an interest rate, which is calculated as a percentage of the loan amount. 


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How Does Interest Work

Interest rates are a percentage of the amount you borrow. That means that if you take out X amount of dollars and the loan’s interest is 5%, then you’ll pay 5% of X amount of dollars to the lender in addition to repaying the loan. 

For example, say you take out a loan for $500 dollars and your loan agreement comes with a 5% interest rate. 5% of $500 is $25. That means that you’ll pay $525 back to the lender in total while making loan repayments. The equation to help you figure out how interest rates apply to your loan look like the following: 

Interest Rate Calculator:

Interest Rate Calculator

Loan Amount x Interest Rate Percentage As A Decimal = How Much You’ll Pay In Interest

Then you just add how much you’ll pay in interest to your loan amount to see how much you’ll be paying back to the lender overall, interest included. Interest rates are often calculated for each loan using a process called loan amortization

What is the Difference Between Interest Rate and Apr?

how does interest work

APR stands for Annual Percentage Rate. APR is a percentage that shows how much a loan cost annually. This rate includes all finance charges that are added to the original cost of the loan, or the principal. This can include things like the loan’s interest rate, origination fees, monthly maintenance fees, and more. 

Interest rate also shows how much a loan costs for a borrower. It’s a fee that is calculated as a percentage of the original loan amount or the principal. But the interest rate doesn’t include other fees and charges that might be applied to the loan. 

The Federal Truth in Lending Act is a policy that requires all lenders to use APR so that borrowers can easily compare their loan options. So no matter where you go to find a loan, you should be able to use APR to easily compare loans and pick the best option for you. 

How to Calculate Interest

Interest is applied to loan payments as a percentage of the loan amount. To calculate basic interest payments, take the principal loan amount and multiply this number by the interest rate as a decimal number, and the loan term. This will get you the total amount you’ll pay in interest. 

total loan interest formula

Loan Amount x Interest Rate x Loan Term = Total Loan Interest 

How much interest you end up paying in total, or the kind of rate percentage you get in the loan agreement, will depend on several individual factors like, credit score, credit history, debt history, income, loan amount, and loan term. For instance, some borrowers will be able to qualify for prime loans with prime rates, while others will only qualify for subprime loans with subprime rates. If you want to qualify for some of the best rates, then you might need to build your credit score up first. 

Part of how an interest rate is calculated depends on what kind of interest is being applied to a loan. There are essentially 5 different kinds of interest rates that your rate might fall under: 

  • fixed interest
  • variable interest
  • simple interest
  • compound interest
  • short interest

Learn about what kind of rate you have in order to calculate the most accurate payments. 

What is Fixed Interest?

Fixed interest is an interest rate that doesn’t change during the entire life of a loan, or during a certain period during the life of the loan. This rate is helpful for borrowers who want to lock in a specific rate and keep that rate throughout all their loan repayments. 

What is Variable Interest? 

Variable interest is an interest rate that does change during the entire life of a loan, or during a certain period during the life of the loan. This rate can be helpful when the market is in the borrower’s favor, causing variable interest rates based on the market to fall. 

What is Simple Interest?

Simple interest is one of the most common and basic kinds of rates. This type of loan rate means that each time you make a loan payment, your payments will first go toward paying off the loan interest and then the principal. By setting up simple interest loans like this, the daily interest accumulation is always paid in full, so it doesn’t accumulate.  

It is calculated on a daily basis, meaning that you’ll want to take your interest rate as a decimal number, and divide that number by 365 days in the year. This will get you the daily interest rate of your loan. Then you’ll take this daily rate and multiply it by 2 numbers—the loan amount and the number of days between each payment. This means that if you are making a payment once a month, then you’ll use 30 for 30 days as your Days Between Payments. 

total simple interest formula

Loan Amount x ( Interest Rate / 365 ) x Days Between Payments = Total Simple Interest 

What is Compound Interest?

Unlike simple interest that keeps up with paying off the interest with each payment, compound interest lets the interest accumulate over time. Because of this, the interest is calculated against the loan principal and however much interest has already accumulated. 

Because this type of loan uses compounding interest, it’s a bit more complicated to calculate. To calculate compound interest on a loan you’ll take the interest rate in decimal form, add 1, and square this total by the number of compounding periods the loan has. Then you’ll take this number and multiply it by the principal. Finally, you’ll subtract the loan principal from this number to get the total compound interest. 

total compound interest formula

1 + Interest Rate = A

A squared by the number of compounding periods = B 

B x Loan Amount = C 

C - Loan Amount = Total Compound Interest 

Short Interest 

Short interest has to do with stocks and investments rather than loans. Short interest occurs when investors use a strategy called short selling. 

Basically, short selling is when an investor predicts the price of a stock or asset they have will decline in the stock market, so they sell the stock with the idea that they’ll be able to buy it back again at a lower price. Selling this stock in the hopes its price will decline is called selling short or “sold short.” Buying this stock back after its price declines is called short covering. 

Short interest is calculated by the number of stock shares that have been sold short but haven’t been short covered. In simpler terms, it’s the percentage of shares that have been sold in order to wait for a price decline, but not bought back again. 

In Conclusion, 

All things come with a price tag and part of a loan’s price tag is the interest rate. This is how loan payments to the lender are calculated and included per loan and per loan customer. If you are having trouble making loan payments, then talk to a loan representative about refinancing.