Understanding Personal Loan Interest Rates

Understanding Interest Rates on Personal Loans

Personal loans are a type of closed-end credit, with set monthly payments over a predetermined period, i.e., three, four, or five years. Interest rates on personal loans are expressed as a percentage of the amount you borrow (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 not including costs related to compounding or the effect of inflation. Most personal loans actually use the monthly periodic rate, arrived at by dividing the APR by 12. When applied to principal, the APR (or periodic rate) determines the additional amount you will pay to borrow the principal and pay it back over time.

Unsecured vs. Secured Loans

All loans are either secured or unsecured. Most personal loans are unsecured, meaning the loan is not backed up by an asset that the lender can take in the event you default on the loan. An example of an unsecured loan could be money you borrow to go on vacation. Unsecured loans are backed up only by your creditworthiness and typically come with a higher interest rate to reflect the additional risk the lender takes.

Loans can also be secured, that is, backed up by something of value. The thing you offer to assure the lender you will repay the loan is known as collateral. A home equity loan is an example of a secured loan, because your home serves as collateral to guarantee repayment of the loan. Secured loans usually have a lower interest rate because the lender takes less risk.

A personal loan calculator is useful for determining how much a high-interest unsecured loan will cost you in interest when compared to a low-interest secured one.

Regulation Z

In 1968 the Federal Reserve Board (FRB) implemented Regulation Z which, in turn, created the Truth in Lending Act (TILA), designed to protect consumers when making financial transactions. Personal loans are part of that protection.

Subpart C — Section 1026.18 of Regulation Z requires lenders to disclose the APR, finance charge, amount financed, and total of payments when it comes to closed-end personal loans. Other required disclosures include number of payments, monthly payment amount, late fees, and whether there is a penalty for paying the loan off early.

Average Interest Rate on a Personal Loan

The average APR on a 24-month unsecured personal loan in the U.S. is 9.34% as of August 2020. The rate you pay, depending on the lender and your credit score, can range from 6% to 36%. For comparison, the average APR on a 48-month secured new car loan is 4.98%. This shows the interest lowering power of a secured loan over an unsecured loan.

Calculation of Personal Loan Interest

Armed with Regulation Z disclosure requirements and knowledge of how interest on closed-end personal loans is calculated, it’s possible to make an informed choice when it comes to borrowing money. Lenders use one of three methods — simple, compound, or add-on — to calculate interest on personal loans. Each of these methods relies on the stated APR provided in the disclosure document.

Simple Interest Method

The most common method used for personal loans is the simple interest method, also known as the U.S. Rule method. The primary feature of simple interest is that the interest rate is always applied to principal only.

Using the example of a $10,000 loan at 10% APR over 5 years (60 months), simply plug the appropriate numbers into one of numerous free online calculators like this Monthly Loan Balance Calculator. In this case, beginning principal balance is $10,000, interest rate is 10%, original term is 60 months, leave payment blank, enter any five-year period, i.e., Jan. 2020 to Jan. 2025, and make sure “US Rule” (simple interest) is selected.

The calculator returns the monthly payment plus total principal and interest over the life of the loan. You can also get a complete five-year amortization schedule telling you exactly how much principal and interest you will pay each month.

As the calculator shows, with simple interest and on-time payments, the amount of interest you pay goes down over time, and the amount of your payment applied to principal goes up, until the loan is paid off. If you make your payments early or make extra payments, you will pay less interest overall and may even pay off your loan early.

If you pay late or skip payments, the amount of your payment applied to interest goes up, resulting in less of each payment applied to principal. Interest (and late fees) are kept separate (escrow). Accumulated principal, interest, or late fees will be due at the end of your loan. Test these assertions by adding to the payment amount, reducing, or deleting payments to see the impact each has on the total you pay.

Compound Interest Method

With the compound interest method, also known as the “normal” or “actuarial” method, if you make all your payments on time, the results are the same as with the simple interest method because interest never accumulates.The same circumstances apply to paying early or making extra payments. Both can result in a shorter loan term and less interest paid overall

If you are late or miss payments with a compound interest loan, accumulated interest is added to principal. Future interest calculations result in “interest on interest.” With this method you will end up with even more leftover interest and principal at the end of your loan term. You can test these scenarios with the same online calculator by plugging in the same numbers but selecting “Normal” as the amortization method. Common examples of the use of compound interest are credit cards, student loans, and mortgages.

Add-on Interest Method

The add-on interest method doesn’t require a calculator. That’s because the interest is calculated up front, added to the principal, and the total divided by the number of payments (months).

Using the $10,000 loan above, to arrive at the amount of interest you will pay, multiply the beginning balance by the APR times the number of years to pay off the loan, i.e, $10,000 x 0.10 x 5 = $5,000. Principal and interest add up to $15,000. Divided by 60, your monthly payments will be $250, consisting of $166.67 principal and $83.33 interest.

Whether you pay on time, early, or late, the total paid will be $15,000 (not including potential late fees). Payday loans, short-term advance loans, and money loaned to subprime borrowers are examples of loans with add-on interest.

Example of Simple vs. Compound vs. Add-on Interest Methods

The table below, shows the differences among simple, compound, and add-on interest when applied to a $10,000 loan at 10% APR over five years with and without missed payments. The amounts shown do not include late-payment fees or other charges, which vary by lender.

Comparison of the three methods clearly shows why you should avoid add-on interest at all costs. It also shows that when payments are late or missed, compound interest adds up. Conclusion: Simple interest is the most favorable to the borrower.

* With a total of three missed payments, one each at the end of years one, two, and three

1 Total principal and interest when paid on time

2 Total principal and interest with three missed payments