Interest, interest rates, interest rate calculations… It can all be confusing to understand. To help clarify some of the various types of interest in lending and reduce confusion, here are five common types of interest relating to loans and the lending industry:

## Types of Interest #1: Simple Interest

Simple interest is a common form of interest lenders charge for a variety of loans, including auto loans, home loans, and personal loans.

Rather than paying compounded, accumulating interest, the borrower only pays simple interest on the outstanding principal, or the amount of the loan that has not yet been paid, at the specified rate per year or repayment term.

### How to Calculate Simple Interest

The simple interest rate calculation is, well, simple because it does not factor in any compounding interest.

The formula includes:

**The Principal**– How much the lender is loaning to the borrower.**The Interest Rate**– The lender’s charge for lending the money, expressed as a percentage of the principal.**The Loan Term**– How many years a borrower has to repay the loan and interest.

For example, let’s say a borrower obtains a personal loan of $10,000 with an interest rate of 5% and has two years to pay it back.

The amount of interest they will owe can be calculated like so:

$10,000 x 0.05 x 2 = $1,000.

By the end of the two years, the borrower would pay back the $10,000 and provide the lender an additional $1,000 of interest.

## Types of Interest #2: Compound Interest

Compound interest is more complex than simple interest, as the interest owed per compounding period includes both the original balance and previously accumulated interest. In other words, the interest per period is calculated based on the principal balance, as well as any unpaid interest that has already accrued.

This is a common type of interest for credit cards, student loans, and some mortgages.

### How to Calculate Compound Interest

Calculating compound interest requires the lender or borrower to factor in the number of compounding periods, the original principal, and the interest rate.

**What is a compounding period**? The compounding period is the frequency at which the interest is compounded within the repayment period. Depending on the loan or lender, the compounding period can be once a year, twice a year, quarterly, monthly, or daily.

Using the same figures used for simple interest, let’s say a lender loans $10,000 to a borrower at 5% per year for two years. But this time, the interest is compounded twice a year. Instead of focusing on the total 5% interest per year, we’re going to divide it by 2 to reflect the two compounding periods in each year.

- 5% / 2 = 2.5% per compounding period

In the first compounding period (the first six months), the borrower’s payment is based on the principal plus 2.5% interest.

- $10,000 x .025 = $250
- $10,000 + $250 = $10,250

The loan payments in the first six months will be based on $10,250.

In the second compounding period (the next six months), the borrower’s interest will now be calculated using the principal and owed interest accrued in the first period.

- $10,000 + $250 = $10,250 x .025 = $256.25

The loan payments will now be based on $10,506.25

In the third period, the interest will be based on the $10,506.25 and 2.5% interest.

- $10,506.25 X .025 = $262.65 + $10,506.25 = $10,768.90

The interest for the fourth and final period is now based on the $10,768.90 at 2.5%.

- $10,768.90 x .025 = $269.22 + $10,768.90 = $11,038.12

After two years, the borrower will ultimately owe the lender the original $10,000 and $1,038.12 in compound interest.

It may not seem like much of a difference between $1,000 of simple interest and $1,038.12 of compound interest. Still, compound interest amounts can significantly increase when there are higher principals and interest rates, longer repayment terms, and more frequent compounding periods.

## Types of Interest #3: Fixed Interest

Fixed interest is a type of interest that remains the same throughout the repayment term. Many home loans, auto loans, and consumer loans are available with a fixed interest rate.

For instance, if a borrower takes out a $20,000 auto loan with an interest rate of 5% APR, the 5% interest rate will not change throughout the life of the loan.

## Types of Interest #4: Variable Interest

Variable interest, sometimes called floating interest, differs from fixed interest in that it changes over time based on changes to the index rate, or the rate lenders rely on to set their interest rates.

Variable rates can apply to credit cards, student loans, HELOCs, and some personal loans. Short-term loans with variable interest rates could benefit borrowers by remaining low throughout the life of the loan. However, there is always the risk that the rates will rise and increase payment amounts, potentially costing the borrower more than they would have paid with a fixed rate.

## Types of Interest Rates #5: Blended Interest Rates

Many state laws require lenders to calculate interest at blended rates (ex: up to $10k at a 10% rate, the next $5k at an 8% rate, the nest $5k at a 6% rate, and so on.)

Blended interest is often used in debt consolidation. It allows borrowers to combine their debts, including home loans, car loans, credit card debts, and personal loans, into a single average interest rate.

For example, if a borrower has a $10,000 auto loan with a fixed APR of 5%, as well as a $10,000 personal loan with a fixed APR of 10%, a lender could combine the loans, creating a blended rate of 7.5%.

Depending on the circumstances, blended interest can help borrowers pay off their debts faster and save money at the same time.

### Whatever Type of Interest Rates You Offer or the Types of Loans You Provide, absVision Is the Lending Software for You.

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