The interest rates on personal loans vary depending on the type, amount, credit rating, and financial institution. Secured loans offer lower rates because of the collateral attached. Generally, banks offer two types of interest rates – fixed and variable. There are other types as well, including discount and amortized.
Nominal and Effective Rate
The effective annual rate determines what borrowers get charged annually. Compounding occurs more than once, with borrowers paying interest on interest. If the rate is 12 percent and you borrow $1,000, you will pay $1,200. When compounding occurs on a monthly basis, the interest rate increases. There are online tools that allow borrowers to calculate it, based on the number of years, terminal value, and initial amount. You can use a formula as well. In this case, you will need the number of compounding periods and the stated interest rate. There are different compounding periods – annually, quarterly, and monthly. Financial institutions also use periodic and nominal rates. The latter is often referred to as the quoted rate. The former determines the amount charged on a monthly basis or each period.
Variable vs. Fixed Rate
Applicants can choose from loans with fixed and variable interest. Borrowers who are looking for a rate that is locked for a certain period usually choose fixed rate loans. This makes budgeting easier while some products also offer a degree of flexibility. The monthly payments stay the same until the end of the term. Generally, a fixed rate loan offers protection against interest rate fluctuations. If interest rates are about to fall, it is better to choose a product with a variable rate. This is a flexible solution that offers lower monthly payments when rates go down. Both types of personal loans have pros and cons. Breaking a fixed rate contract can be costly. The fee can be very high. In addition, banks assess other fees such as prepayment, early exit, ongoing, and establishment fees.
Some borrowers choose to split the loan and pay a certain amount at a fixed rate and the remainder at a variable rate. There are different factors to consider when choosing whether to split, float, or fix, including the type of property, predictability, and flexibility. If you anticipate major changes to your business, employment status, income level, or family arrangements, you may want to lock in. Whether you borrow to finance the purchase of an investment property or your primary residence is another factor that plays a role.
Amortized Interest
Financial institutions also offer car loans and mortgages with amortized interest. Borrowers pay a portion of the principal and all of the interest due. This arrangement is different from interest-only payments. To illustrate, if you borrow $2,000 at 8 percent, you owe $2013.13 after one month ($2,000 x 0.08 = $160; $160 / 12 = $13.33). But if you paid the bank $14, your balance would be $1999.33. Your interest charges would be lower.
Negative Rates
In principal, there are negative nominal rates meaning that financial institutions pay customers to lend them money. While this is unlikely to occur, real interest rates sometimes go to or below zero. When inflation and interest rates are equal, we can speak of a zero nominal rate. The rate is 3 percent when inflation is also 3 percent.
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