Interest Rates: What Are They, and How Do They Work?

If you're thinking of applying for a loan, it's important to know understand how interest rates work. All loans have some type of interest rate attached to them, either as a percentage or as a flat rate. When you repay the loan, you'll need to repay whatever you borrowed, plus any applicable interest rates.

Let’s dive deeper into what interest rates are, how they work, and how to calculate them.

What are interest rates and how do they work?

Interest rates are the costs you pay to borrow money. They’re usually expressed as a percentage and affect the total amount you’ll pay for a loan. Interest rates compensate lenders for the risk of lending to you, and it's their way of making money.

All loans have interest rates, but some are higher than others. Because you'll have a higher repayment cost for loans with higher interest rates, it's important to choose a loan with rates as low as possible. Interest rates can be confusing and vary from lender to lender. They, along with the amount of the loan, make up the principal, which is the total amount you will need to repay. 

For example, if you borrow $1,000 with a 5% interest rate, the total amount you will pay for your loan will be $1,050.

How to calculate interest rates

Most loans use a simple interest rate. Here's how to calculate it:

Simple interest loan

Simple interest = principal loan amount x interest rate x time

For example, if you apply for a 30-year mortgage with a loan amount of $200,000 at 4%, here's how you calculate your total payment:

$200,000 x .04 x 30 = $240,000 in total interest at $8,000 per year for 30 years.

Another example is let's say you take out a Payday Loan for $200. Payday Loans typically have a fixed interest rate of $15 for every $100 borrowed, putting the total principal for your loan at $230.

>More: APR vs. Interest Rate

When do borrowers have to pay interest?

The type of loan you choose will determine when you pay interest. Here’s how interest works with several different types of loans.

Payday Loans

Once you receive your money from a Payday Loan, you’ll need to repay it in full plus interest when you get your next paycheck. In many cases, your payment term will be within two to four weeks.

Line of Credit

You can borrow as much or as little money as you’d like up to your set credit limit. You’ll pay interest on the amount of cash you withdraw during the repayment period, not on the entire Line of Credit.

Installment Loans

After you receive a lump sum of money, you’ll pay it back plus interest via a fixed number of monthly payments or installments. You’ll do this during your repayment term, which can be anywhere from several months to several years, depending on the size of your Installment Loan.

Title loans

Upon approval, you’ll repay your title loan with interest when your loan repayments are due, which can vary depending on the lender and loan terms. Fortunately, you’ll be able to continue driving your vehicle while you do so.

High vs. low interest rate

When looking for the right loan, you may be wondering what the difference is between high and low interest rates. Loans with a high interest rate are more expensive for borrowers than those with a lower interest rate, and a high interest rate means you’ll have to pay more over the life of the loan.

High interest rates also usually mean that your loan is for a shorter term and a smaller amount. As such, even though you are paying a higher interest rate, you'll pay a smaller overall principle since you're making fewer payments.

What determines a loan interest rate?

Every lender is allowed to determine their loan interest rates, and they typically use the following criteria to make their decision:

Loan amount

In general, the larger your loan amount, the lower the interest rate. Lenders know that with a larger loan, you'll have a longer repayment period, so they don't need to charge a high interest rate.

Loan type

Different types of loans will have different interest rates. Payday Loans and Installment Loans, for instance, typically have higher interest rates than mortgages and student loans. This is because Payday and Installment Loans are usually smaller and have a shorter repayment window.

Interest rate type

Depending on the loan you take out, you may pay a fixed interest rate or variable interest rate. A fixed interest rate remains the same over the life of the loan, while a variable interest rate changes based on the market.

Loan repayment terms

The amount of time you must pay back your loan will also affect its interest rate. In most cases, the shorter the repayment window is on your loan, the higher your interest rate will be.

How to get good loan interest rates

Here are some ways you can get the best interest rate possible on a loan:

  • Compare loan options: There are many lenders out there offering loans with varying interest rates and terms. Make sure to do your research and compare options to find a loan with interest rates that work for your budget.
  • Improve your credit score: Improving your credit score can help you qualify for loans with lower interest rates. You can improve your score by making consistent on-time payments, paying off debt, and disputing any errors on your credit report.
  • Opt for a shorter repayment term: You can often save on interest by choosing a loan with a shorter repayment window. Although your monthly payments may be higher, you may end up saving money by paying less in interest.

Other ways to save money on your loan

If you can't find a loan with the interest rates you want, the best way to save money on your loan is by repaying it as quickly as possible. The sooner you repay your loan, the less time interest will have to accrue. That way, even if you have high interest rates, you will only have to pay interest for a month or two if you can quickly repay your loan.

How do Advance America interest rates work?

We offer different types of loans, including Payday Loans, Installment Loans, and Lines of Credit with varying interest rates. Unlike loans from other lenders, your credit score doesn't matter and won't affect your interest rate.

With Payday Loans, we typically charge a flat interest rate of $15 for every $100 borrowed (rates and loan availability vary by state). Interest rates for Installment Loans and Lines of Credit will vary according to your state of residence and the size of your loan.

Visit your nearest Advance America store to learn more about the loans we offer – or apply online now.

About the Author

Jalin Coblentz has contributed to Advance America since 2023. His experiences as a parent, full-time traveler, and skilled tradesman give him fresh insight into every personal finance topic he explores.

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