When you borrow money from someone, or you lend some money, the cost that you pay or earn is referred to as interest. It is the percentage of the total amount that is added in the balance periodically. You can refer to it as a fee for using the money. It keeps on adding till the time the whole debt amount is repaid.
How does interest works?
It is important to know how interest works. This makes you understand how your balance does not lower down despite your regular payments.
There are two types of interest:
- Simple Interest
- Compound Interest
Simple Interest is the flat interest on the principal balance. Let’s say there is a loan of $1000 and the interest rate is 15%. Then every year, $150 gets added to your loan amount. If the debt remained unpaid for three years, then the interest becomes $450.
If we talk about compound interest, it is charged on the original amount, plus on the interest and fees that get added to the balance. Here you are paying interest on the interest, and you will end up paying $70.88 more than simple interest. When a compound interest adds to the loan amount, it prevents loan amount from lowering. Here most of your payment is eaten up by the cost of interest.
Most of the financial products use compound interest, so it is necessary to pay off the debt in the speediest manner.
Understand how interest rate works and clear off your debts quickly.