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How do finance companies calculate interest?

How do finance companies calculate interest?
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When you borrow money from a lender, whether it’s for a business loan or personal loan, you’ll need to pay back this loan with interest. In some instances, the final amount you end up paying back over time can be more than double the amount you originally borrowed. Interest is in place so that the finance company makes a profit, and it is worth their while to lend you money.

But how do finance companies calculate interest? In this article, we’ll have a look at some of the factors that contribute to the interest percentage that is placed on your loan and the equations used to calculate specific interest amounts.

What is loan interest?

In simple terms, interest is the difference between the total amount you pay back to the finance company and the original amount you borrowed. It is the profit that finance companies make from lending money out to borrowers. There are different types of interest, with the two main types being simple and compound interest.

How finance companies calculate interest

Simple interest is straightforward to calculate. It is the principal loan amount x interest x time= Interest.

The formula for compounded interest is P (1 + r/n)^(nt), where P is the initial, principal amount, r is the rate of interest, n is the number of times interest is calculated per time period, and t is the number of time periods.

Compounded interest will always end up being a lot more in the long run, but not many companies will lend money using simple interest.

Factors that affect the interest amount

Many factors influence the interest amount that finance companies will impose on loans. Some of these factors include:

Loan amount

The amount you need to borrow from the finance company will heavily affect the interest amount they assign to your loan. The larger the loan amount, the more interest that you can expect to pay, as there is a greater risk involved for the finance company, and it will take longer for them to receive their money back.

Credit score

Having a good credit score is imperative to apply for loans. A good credit history shows that you are responsible with your money and take your repayments seriously. Having no credit history can sometimes be just as bad as having a bad credit score, as the lender has no idea what your money management skills are like. A credit score is essentially like a reference or CV that finance companies can use to see your repayment abilities.

Repayment schedule

If you are wanting to get a loan at a lower interest rate, try and make your repayment time frame as short as possible. This means that you’ll have to pay a larger amount back each month, but over time you will definitely save as you’re more likely to get lower interest with short-term loans.

Long-term loans often have higher interest rates. While it may seem easier to pay a smaller amount each month for a longer period, you’ll generally pay a lot more over time.

Collateral

It is very common in business loans to offer up some of your assets, such as vehicles, property, and shares, as collateral. This is a way of getting better interest rates, as the finance company has the reassurance that they can take your assets as collateral should you have any issues with the repayment schedule.

The finance company

Each and every finance company will have different loan options, with varying rates of interest available. This is why it’s important to look around before deciding on one lender to borrow from. As someone looking to borrow money, you have a wide variety of options available to you, and you should shop around for the best possible option.

When dealing with a finance company, feel free to ask questions about how they calculate interest and what sort of interest options they have available for your specific situation.

Employment & income

Depending on the type of loan you decide to take out, you’ll need to provide some sort of proof of employment or income. This shows the lender that you are getting a stable income every month and should be able to pay the loan back. This also affects the repayment schedule that the lender feels secure in giving, which in turn will affect the interest rate attached to your loan.

Available documentation

The documentation that you can provide the lender with will also play a role in calculating the interest rate attached to the loan. In most cases, the more financial proof and documentation that you are able to produce in your favour, the better.

What you should understand is that interest rates are mostly customised to the borrower’s specific situation. Knowing how finance companies calculate interest on loans can help you prepare yourself to apply for a loan and find an affordable interest rate.

Ensure that you’ll be able to pay the loan back

Interest amounts can often be deceiving, so it’s very important that you understand the exact amount you’ll be expected to pay every month, when the money will be due, and what the terms of the loan are. You should also ensure that you understand the long-term penalties for not being able to make certain repayments on time. The last thing you want to do as an individual or business owner is getting into a loan repayment plan that you can’t afford to pay off. When applying for a major loan, it is advisable to look through it with a financial advisor to ensure that all the terms work for you.

 

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