Interest rates. We have a love-hate relationship with them. Especially when it comes to the level they’re sitting at. Some people love interest rates because they can mean they can earn more money. In contrast, borrowers dislike interest rates because they can result in higher loan payments to buy big ticket items.
But what is an interest rate? An interest rate is the price you pay to borrow money. It can be thought of as the “cost of money” and is a percentage of the principal amount loaned. Generally, an interest rate will be calculated on an annual basis and shown as an annual percentage rate (APR). Interest rates apply to most lending and borrowing transactions which can include cars, boats, equipment, business expenses and travel expenses.
For a loan, the interest rate will be applied to the principal amount (the amount of the loan). Therefore, the interest rate is the cost of debt for the borrower and the rate of return for the lender. The difference between the total repayment amount and the original loan is the interest charged. Low risk and high risk borrowers are charged interest rates according to their level of risk. Low risk borrowers will generally receive lower rates and thus a lower cost loan, while high risk borrowers receive higher rates and thus a higher cost loan.
What is a Variable Interest Rate?
Also sometimes referred to as an ‘adjustable’ rate, a variable interest rate is an interest rate on a loan that fluctuates over time. The fluctuation happens due to the rate being based on an underlying benchmark interest rate.
Variable interest rates can be advantageous to borrowers if the underlying rate declines because it means the borrower's interest payment will also fall. The downside of variable interest rates is that if the rate rises, the borrower’s interest payments will increase. When it comes to the underlying benchmark interest rate for a variable interest rate, it is highly dependent on the type of loan being acquired. Variable interest rates can be found in credit cards, personal loans, student loans, and some auto loans.
| PROS | CONS |
|---|---|
| Variable interest rates are generally lower than fixed interest rates | Variable interest rates can go up significantly and the borrower can struggle to repay the loan |
| When interest rates decline, the borrower benefits | Variable interest rates are unpredictable |
| If interest rates increase, the lender benefits | Variable interest rates are harder for a lender to predict future cash flows |
Fixed Interest Rates Explained
Fixed interest rates are pretty simple. It’s a rate that doesn’t change throughout the life of your loan, or for part of the loan. With a fixed interest rate, a borrower will pay an agreed amount of interest on their loan for a set period of time.
Variable interest rates are the opposite of fixed interest rates. However, both types of rates refer to interest that is added to the amount borrowed. When a borrower makes a repayment on their loan, the repayment amount will include part of the principal amount and the interest incurred. People generally choose a fixed interest rate because it won’t change for the duration of the loan term. This consistency can be useful for planning your finances and can be considered a safer choice if you need to know what to budget each month.
| PROS | CONS |
|---|---|
| Rate rises won’t impact you, saving you money on repayments in the future | Fixed rate loans can limit your ability to pay of your loan faster via additional payments |
| Repayments will stay the same throughout the loan period | You won’t benefit from any interest rate falls |
What is a Flat Interest Rate?
- Early repayments
- Some sort of credit if that happens
- Specify business only
A flat interest rate is a loan where the interest is calculated on the original loan amount for the entire loan period. Under a flat interest rate, the repayments will be equal throughout the loan term. Flat interest rates will generally result in higher overall interest payments compared to fixed interest rates. This is because flat interest rates are calculated on the full original amount of the loan for the entire term, while fixed interest rates are calculated on the decreasing loan amount as you repay the loan.
There are a number of reasons why someone would choose a flat interest rate for their loan. Firstly, the calculation is simple and easy to understand how much interest will be paid over the life of the loan. Secondly, monthly payments under a flat interest rate are fixed and predictable which can make budgeting easier. Thirdly, it can be far easier to compare loans with flat interest rates because the interest rate calculation doesn’t change over time. Finally, regardless of how much the loan is repaid, the interest will stay the same which can offer a sense of stability for some borrowers.
| PROS | CONS |
|---|---|
| Easy to calculate | Higher overall interest costs |
| Predictable, fixed payments resulting in easier budgeting | Borrower won’t benefit from early repayments |
| Consistent repayment amounts | Is not reflective of the actual loan balance Can be more expensive |
Annual Percentage Rates (APR)
Simply put, Annual Percentage Rate (APR) is the true cost of borrowing money. It includes the interest rate as well as any other fees associated with the loan. APR is expressed as a yearly percentage and represents the annual cost of funds over the life of your loan.
The APR gives consumers a bottom-line number they can compare among lenders, credit cards, and investment products. It differs from interest rate for a number of key reasons. In short, while the interest rate tells a borrower how much they will pay in interest alone, the APR will tell them the total cost of the loan including fees.
| Interest Rate | APR (Annual Percentage Rate) |
|---|---|
| Only includes the cost of borrowing money | Includes cost of borrowing money plus additional fees |
| Easier to calculate | Harder to calculate |
| Good for understanding basic loan cost | Better for comparing overall loan costs |
Comparison Rate
A comparison rate is a legal requirement for lenders to display next to their advertised interest rates. Comparison rates refer to the true cost of the loan inclusive of fees and make it easier for borrowers to compare different loan products available by multiple lenders.
| PROS | CONS |
|---|---|
| Includes interest and fees | Might not include all possible fees |
| Easier to compare loans | Can vary between lenders |
| Reflects true cost of borrowing | May not reflect individual borrowers situation |
| Helps avoid hidden costs | Can be complicated to calculate |
Closing Thoughts
When making borrowing decisions, it is important to remain educated on the market. Understanding different types of interest rates is an integral part of this. Whether you’re considering a variable, fixed, or flat interest rate, or evaluating the APR and comparison rates - each type of interest rate has its own advantages and disadvantages. For a full rundown of each rate type ahead of your next loan application, the brokers at Jade Finance are extremely knowledgeable and eager to help.
Looking for a low interest rate on your next big ticket purchase?
JADE Finance consultants are highly trained, fully licensed financial professionals who can accurately assist you with securing a low interest rate for your specific financial situation.
We ensure the loan application process is as streamlined and stress-free for you as possible, providing workable financial solutions to help you achieve your financial goals.
By providing our brokers with a few details, your circumstances will be thoroughly considered to determine the best way forward for you.
" alt="">