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Monday, April 23, 2012

A Simple Guide to Understanding Interest Rates


You need to understand how interest rates work when it comes to dealing effectively with the money you work hard to earn. This is the case if you want to be a credit card holder. The same can be said if you plan to buy a car, a home or apply for a loan or line of credit with your bank. You need to understand interest rates for every bill you need to pay! 

We all need a basic understanding of what interest rates are and how they work. Even if you do not have a head for figures the basic math behind interest rates is something that everyone can learn, and indeed needs to learn for all future money matters. 

What is Interest?

In its most basic form, interest is money that is above and beyond the principal of money that is borrowed. If you borrow money from someone who is deemed a lender of money then you have incurred a debt and it is necessary to repay the debt. Interest will be charged on your account based upon the amount of money that is owing.

What interest is can be explained like this:

Interest is a percentage of the total owing on the debt and this is periodically added to the total outstanding balance as a type of fee for the privilege of using the money. Interest is not a one-time thing but it continues to add up until the point at which the debtor pays the debt in full. 

What is an Interest Rate?

An interest rate is the exact percentage of the total debt that is charged to the account. Interest rates are something no one can escape if they choose to borrow money in any manner. Interest rates are charged on loans, credit cards, mortgages, utility bills, medical bills and so on. How much interest is charged on each individual item varies and the credit histories of each consumer also play a role. 

Understanding Interest Rates

Before you even consider taking out a loan or applying for a credit card, it is important to understand how interest and interest rates work. If you do not take the time to learn about interest then you will not have a clear idea of what your debts are actually costing you to pay off and you might find yourself extremely frustrated that your balances decreases at an extremely slow rate despite the fact that you pay your bills as faithfully as possible.

Two Types of Interest

There are basically two kinds of interest. They include simple interest and compound interest. Here we will look only at simple interest in order to better understand how interest rates work.

Simple interest is just that- it is simple and straightforward to comprehend. Simple interest is also sometimes called “flat rate” interest and it is a percentage of the complete balance that a debtor owes to a creditor. 

The formula for calculating simple interest is as follows: 

Interest = Principal x Rate x Time

To use a practical example, if you borrow a loan for $1000 and the yearly interest rate  attached to the loan is 15 percent then this means that after one year has gone by, the debtor would owe $150 in interest charges. This equation looks like this:

1000 x .15 = $150

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