Understanding Personal Loan Interest Rates
Personal loans are a type of closed-end credit with fixed monthly payments for a set period of time, such as three, four, or five years. Personal loan interest rates are expressed as a percentage of the amount borrowed (principal). The rate quoted is the nominal annual percentage rate (APR), or the rate applied to your loan each year, including any fees and other costs, but excluding compounding costs and the effect of inflation. Most personal loans use the monthly periodic rate, which is calculated by dividing the APR by 12. The APR (or periodic rate) when applied to principal determines the additional amount you will pay to borrow the principal and repay it over time.
- The interest rate on a personal loan is expressed as a percentage of the amount borrowed.
- The majority of personal loans are unsecured, meaning they are not secured by a recoverable asset or collateral.
- Personal loans with no collateral have a higher interest rate than secured loans.
- Personal loan interest is calculated in one of three ways: simple, compound, or add-on, with simple being the most common.
Loans: Unsecured vs. Secured
Every loan is either secured or unsecured. Most personal loans are unsecured, which means they are not secured by an asset that the lender can seize if you default on the loan. An example of an unsecured loan is money borrowed to go on vacation. Unsecured loans are backed solely by your creditworthiness and typically carry a higher interest rate to reflect the lender’s increased risk.
Loans can also be secured, that is, they can be backed up by something valuable. Collateral is the item you offer to assure the lender that you will repay the loan. A home equity loan is an example of a secured loan because your home serves as collateral to ensure loan repayment. Because the lender assumes less risk, secured loans typically have lower interest rates.
A personal loan calculator can help you figure out how much interest a high-interest unsecured loan will cost you versus a low-interest secured loan.
The Federal Reserve Board (FRB) implemented Regulation Z in 1968, which resulted in the Truth in Lending Act (TILA), which was designed to protect consumers when making financial transactions. Personal loans are a component of that safeguard.
When it comes to closed-end personal loans, Subpart C—Section 1026.18 of Regulation Z requires lenders to disclose the APR, finance charge, amount financed, and total of payments. Other required disclosures include the number of payments, the amount of each monthly payment, late fees, and whether or not there is a penalty for paying off the loan early.
Personal Loan Interest Rates on Average
As of August 2020, the average APR on a 24-month unsecured personal loan in the United States is 9.34 percent. The interest rate you pay can range from 6% to 36%, depending on the lender and your credit score. In comparison, the average APR on a secured new car loan for 48 months is 4.98 percent. This demonstrates the interest-saving ability of a secured loan over an unsecured loan.
Personal Loan Interest Calculation
When armed with Regulation Z disclosure requirements and understanding of how interest on closed-end personal loans is calculated, it is possible to make an informed borrowing decision. Lenders calculate interest on personal loans using one of three methods: simple, compound, or add-on. Each of these methods is based on the stated APR in the disclosure document.
Method of Simple Interest
The simple interest method, also known as the US Rule method, is the most commonly used method for personal loans. The primary characteristic of simple interest is that the interest rate is always applied only to the principal.
Simply enter the appropriate numbers into one of numerous free online calculators, such as this Monthly Loan Balance Calculator, for a $10,000 loan at 10% APR over 5 years (60 months). In this case, the starting principal balance is $10,000, the interest rate is 10%, the original term is 60 months, the payment is left blank, any five-year period, i.e., January 2020 to January 2025, and “US Rule” (simple interest) is selected.
The calculator calculates the monthly payment as well as the total principal and interest paid over the life of the loan. You can also obtain a detailed five-year amortization schedule that shows how much principal and interest you will pay each month.
The calculator shows that with simple interest and on-time payments, the amount of interest you pay decreases over time while the amount of your payment applied to principal increases until the loan is paid off. If you pay your bills on time or make extra payments, you will pay less interest overall and may even be able to pay off your loan sooner.
When you pay late or skip a payment, the amount of your payment that is applied to interest increases, resulting in less of each payment being applied to principal. Interest (as well as late fees) are kept in a separate account (escrow). At the end of your loan, any accumulated principal, interest, or late fees will be due. Test these assertions by increasing, decreasing, or deleting payments to see how each affects the total amount you pay.
Method of Compound Interest
Because interest never accumulates, the compound interest method, also known as the “normal” or “actuarial” method, produces the same results as the simple interest method if all payments are made on time.
The same rules apply if you pay early or make extra payments. Both can result in a shorter loan term and less overall interest paid.
If you miss or are late on a compound interest loan payment, the accumulated interest is added to the principal. Calculating future interest yields “interest on interest.” You will have even more leftover interest and principal at the end of your loan term if you use this method. You can run these scenarios through the same online calculator by entering the same numbers but choosing “Normal” as the amortization method. Credit cards, student loans, and mortgages are common examples of how compound interest is used.
Method of Adding Interest
The add-on interest method does not necessitate the use of a calculator. This is due to the fact that interest is calculated in advance, added to the principal, and the total divided by the number of payments (months).
To calculate the interest on the $10,000 loan, multiply the starting balance by the APR multiplied by the number of years to pay off the loan, i.e., $10,000 x 0.10 x 5 = $5,000. The total of principal and interest is $15,000. Your monthly payments will be $250, divided by 60, consisting of $166.67 principal and $83.33 interest.
Regardless of whether you pay on time, early, or late, the total amount paid will be $15,000 (not including potential late fees). Loans with added interest include payday loans, short-term advance loans, and money loaned to subprime borrowers.
Simple vs. Compound vs. Add-on Interest Methods Exemplification
The table below compares simple, compound, and add-on interest rates when applied to a $10,000 loan at 10% APR for five years with and without missed payments. Late fees and other charges, which vary by lender, are not included in the amounts shown.