At the time of taking out loans from banks, financial institutions, and other standard creditors and lending agencies, we are aware of the fact that we need to repay the original amount of money taken out a loan (principal) as well as an additional amount known as interest. The interest is the profit that creditors and lenders earn through their business of lending loans. The borrower agrees to pay the interest to the lender when taking out a loan.
When explained as a notion of profit, it can be stated that the interest is the value of the funds that are given as loan in case the source or the owner of those funds opted to use that money for income making activities, such as investment in businesses or depositing in banks, instead of giving it as loans to a borrower.
Interest is a very easy concept for economists and mathematicians. However, in the case of the average person, interest can mean the loss of a significant sum of money when it is misconstrued as a yearly, fixed, or simple percentage of the debt or loan. Provided below is an explanation about the deeper meaning of interest when it is associated with loans, as well as varied ways to reduce payments via different tactics.
The fundamental meaning of interest
Complete transparency or disclosure on the corresponding annual compounded rate of interest on debts or loans is the normal international practice amongst banks and financial companies. This compulsory requirement assists borrowers and consumers in identifying the full sum of money they have to pay and for comparing the ‘cost’ of one loan with another.
Discussed below are some terms related to interest that every borrower should know of.
- Compounded/compound interest payment: A compounded/compound interest is one that borrowers pay for the loan (principal) in addition to the total interest accrued from past years/months. Simply put, it is an interest that is earned over the interest levied.
- One of the major financial products to feature compound interest is credit cards. Thus, if a purchase made via credit card is not repaid in full and if there is already a minimum payment due on the card, then the next bill will feature the minimum due (A), the amount remaining for the new purchase (B), the interest on the minimum due (C), the interest on the sum remaining for the new purchase (D), and the interest accrued on A+B+C+D.
- All of us know that paying the minimum sum due can rapidly grow the compound interest. But some cardholders think that the figures listed in their total purchases or total credit is the actual amount that they owe. They do not include the compounded interest that will get added to the bill if they fail to repay the entire amount charged to the credit card for varied purchases. Paying the minimum due or an amount just over the minimum due will result in the compounded interest being levied.
- Accumulation of interest payments: Most debt and loan instruments apply compound interest. Hence, it is important to know how it works.
- Knowledge of compounded interest allows borrowers to become fully aware of the total amount of money that they have to pay, either as a part of their savings account or a percentage of the loan/principal.
- E.g., after a loan is approved and sanctioned, a part of the loan/principle and the agreed-upon interest sum is billed for payment during the first repayment schedule. The interest on the next bill payment is calculated based on the original loan plus interest earned previously. This process applies to all payments in the future.
- Thus, compounded interest earns more and more money as profits for the lenders while it results in more and more repayments for borrowers.
How to avoid the dangers of compounded interest?
Listed below are some ways to avoid paying higher repayments in compound interest:
- Find compound interest alternatives: Select a loan with simple interest. In this, interest is charged for the entire burrowed amount or loan and it does not grow or compound over time. Thus, just the principal/loan amount creates interest.
- Payments for simple interest funds may be lower as compared to compound interest loans, but consumers may not necessarily enjoy the lowest terms of payment. There is also accumulation of late payments on loans with simple interest.
- Fixed interest loans are those where the rate of interest does not change for the term of the loan. It can be applied for a specific period or the entire loan repayment duration. Fixed interest loans are generally availed for mortgages and consumers can get the most benefit out of it by taking out a home loan when interest rates are really low. Variable interest rates tend to change as per market conditions.
- Check out funding help offered via livelihood schemes: People can take out loans from non-profit capital fund or public assistance programs instead of loans from banks or private lenders.
- Many different credit lines are provided by the government for such purposes. They have flexible terms of repayment and feature lower rates of interest as compared to bank loans.
- Negotiate a personalized repayment with a flexible rate of interest: Some lenders provide personalized terms of repayment for loans. It is dependent on different factors such as the financial status of the borrower, income sources, business and personal assets, and guarantors.
- Seek the help of others who have taken out such loans before applying. Ensure that there are no vague or hidden terms during the negotiation process else the interest charged can be higher than even compounded interest. Seek legal counsel on the special terms offered to you.
- Customers who have repeatedly shown financial responsibility in repayments and have consistently repaid past loans to the same lender, or different lenders, may be able to avail of such special repayment schemes.