What is "Interest" anyways?

Posted on: 28 May 2020

By: Daniela Bucay

What is so interesting about interest, you may ask yourself. First of all, I will not apologize for that or any other puns. Secondly, although interest has many uses in the financial world, for the purposes of this post, we'll stick to how it applies to consumer loans.

Interest is a big part of what determines loan cost. At its simplest, you can think of interest as the extra you pay on a loan, in addition to the money you've borrowed (the principal). The other main ingredient in total loan cost is fees, but we'll get to that in a later post.

Fast Fig Facts on Interest

  • There are a few different types of interest calculations, including simple interest and compound interest.
  • Interest rates determine how much you'll pay back on your loan, in addition to what you borrowed.
  • Lenders calculate interest as a percentage of the money you've borrowed and add it to the principal when structuring payments.
  • For consumer loans, APR tells you the interest rate. APR is not always reliable, however, as it measures the equivalent interest rate over the course of a year, but your loan may not last a full year.

Read on below for more information on how lenders calculate interest, what to look for when evaluating a loan on interest, and some resources on understanding interest more deeply!

Why Charge Interest?

In an ideal world, interest rates would be nominal. However, borrowers pay lenders interest for 2 reasons. First, money costs money. When an investor, for example, lends a business money, they charge interest to the business because they want to make money back, plus a profit, on the money they lent out. They could otherwise just invest the money in the stock market and see it grow that way, provided the market is good.

The second reason for interest, which also helps explain different interest rates, is risk. When you lend out money, you do not have a guarantee of ever seeing it again. To offset the risk of losing money, you charge extra on that money. This makes sense when you consider a larger borrowing pool. At Fig, for example, we set our interest rates knowing, from experience, that a certain portion of our borrower pool will never repay their loans. In order to avoid losing money all the time, other loans have to pay a higher interest rate to counteract the loans that default. When you see a high interest rate on a loan, you can safely assume that the lender has a higher-risk borrower base.

At Fig, our goal is to continuously refine our underwriting process to lower the rate of defaults on loans, so that we can then lower the interest rates for the loans themselves and reward the majority of our customers, who pay back their loans responsibly. It is a difficult process that requires constant work, but we believe it is the right thing to do! Our super-smart underwriting allows us to outperform other lenders on losses and offer rates that they can't beat.

The Main Types of Interest

There are two main types of interest: simple and compound. This Motley Fool article does a good job at breaking down the differences between each type.

Simple interest is, as the name implies, simpler to calculate. You just take the interest as a percentage of the principal and multiply by the length of time. So, for example, if you take out a $500 loan at 200% interest over the course of one year, you'd pay back $1500, as follows:

Total cost = principal + interest, and interest = principal x interest rate x length of time

Plugging in the numbers from our example above, you get interest = $500 x 2/year x 1 year = $1000. Then, total cost = $500 + $1000 = $1500.

Things get a little more complicated once we start talking about compound interest. With compound interest, the interest gets applied to an amount that keeps changing, because previous interest is added to the principal. You want compound interest in your savings vehicles, like a savings account, investment account, or retirement account, because you get more money back.

You don't want compound interest in credit. This is how, for example, credit card debt can spiral so quickly out of control. Let's say you owe a balance of $500 on your credit card, which has an interest rate of 20%, applied monthly. The next month, you will owe $600. If, however, you carry that balance over another month, your balance grows to $720, because the interest that got added was 20% of $600, not of $500. For more on credit card interest, we recommend this blog post, and this blog has more resources for interest rate questions, too!

Interest on Consumer Loans

Most installment loans, like Fig's, use a version of simple interest. The math can get a little wonky, as I learned when I tried to arrive at Fig's interest rate using the simple interest calculation. For example, a $500 loan in Texas at Fig costs $723.08, at an APR of 199%, over 4 months. When I tried to do the calculation using the simple interest formula above (total cost = principal + interest, and interest = principal x interest rate x length of time.), I got something super strange!

Interest = principal x interest rate x length of time, so interest = $500 x 1.99/year x (4/12) = $331.67

If we add that to the $500 principal, that would bring the total cost to $831.67, which it is not!

This brings us to our next point. Installment loans, like mortgages and auto loans, are amortized loans. This fancy word just means that payments are divided into equal payments over the term of the loan, but the proportion of each payment that goes towards interest vs. principal changes over the course of the loan. The internet has many amortization calculators that allow you to plug in your loan amount, loan term, payment amount, and payment frequency, and spit out the correct monthly payment amount. I like this one because it also explains amortization.

If you are math-inclined, you can check out the Wikipedia page on amortization calculators to see the mathematical formula and how it was derived. I will not, however, join you! You want to keep in mind amortization schedules, however, because they can allow you to save money if you repay your loan early.

Early Repayments and Late Interest

As this Investopedia article explains, because the amount of interest you pay goes down over time with an amortized loan, you can also end up paying less interest overall by repaying your loan early. At Fig, we pass these savings on to you, by not charging you for any interest you have not yet accrued (since it accrues monthly) if you repay your loan early. Many other borrowers charge a penalty for repaying your loan early, or they just don't offer the discount because they use the add-on interest method, where the interest is applied up front, regardless of how long it takes to repay your loan.

Many other borrowers will also charge late interest, where if you make a payment late, they will charge additional interest on that late payment, and the amount of your payment (once you do pay it) that goes towards principal is reduced, meaning you have not paid down as much of your loan as you would have had you paid on time. Once again, we don't believe in doing that, which is why at Fig, we not only never charge late fees, but we also never charge late interest!

Total Loan Cost

As we explained in our post comparing Fig vs. other online lenders, APR (and interest rates) are only a piece of the puzzle of total loan cost. You can only really compare loans by APR when they have the same loan term and fee policy, as many loans that advertise a lower APR can sneak in costs via hidden fees, and can end up costing you more money in the long run. For more on fees, stay tuned for our next post!

Have questions about interest rates? Do you want to see your Fig loan payments dissected with an amortization schedule? We'd love to hear from you! As always, you can reach us at service@figloans.com, and on Facebook, Instagram, and Twitter!