How do loan interest rates work?

One of the biggest concerns – if not the biggest concern – for those considering taking out bank loans is interest. And how do loan interest rates work?

What are loans?

A loan is an agreement made between the applicant and the financial institution, where the client receives the transfer of a sum of money, which must be returned within a certain period of time, with some additions.

Offered by banks, financial institutions, and, in recent years, by so-called fintechs, a loan can have a variety of purposes: paying off debts, traveling, getting married, renovating a home, etc.

Due to the COVID-19 pandemic, many people lost their jobs and, in many cases, fell into debt. This led to an increase in demand for loans. However, while this may seem like a good way to get out of debt, when opting for this type of contract, it's important to be mindful of the interest rates.

What is interest?

Interest is present in almost all types of financial transactions and is charged when you delay paying a bill, for example. This results in you paying more than you would have initially.

Depending on the sector, the values of these interests may be higher or lower.

Each type of transaction works with specific interest rates, such as: simple interest, compound interest, default interest, nominal interest, revolving interest, and so on.

In the area of loans, interest is basically the amount you pay to be able to use the money you borrowed for a certain period of time.

When you take out a loan, in the future you will have to pay back the same amount you borrowed + an extra amount as a kind of “payment” for the use of the money you took from the chosen institution.

This extra amount is the interest.

Simple Interest and Compound Interest

Today we are going to talk about two interest models: simple interest and compound interest.

When it comes to loans, institutions typically use compound interest. However, simple interest can also be used in this type of transaction, but this usually occurs when the repayment term is shorter. Even so, the use of simple interest is still rare.

Therefore, when applying for a loan from a bank or financial institution, it is very likely that you will pay compound interest.

To help you understand better, we'll quickly explain two types of interest and how they work.

Simple interest:

As the name suggests, these are simpler and are often used in everyday financial transactions, such as some credit cards and loans. In this model, the interest rates remain unchanged throughout the transaction, meaning the interest rate remains unchanged until the end of the contract.

Compound interest:

I bet you've heard of this modality by another name. It's the famous—and dreaded—"interest on interest."

Unlike the previous model, they are calculated based on the total value of the transaction plus the amount of simple interest. This type of interest is quite common in long-term investments. It sounds complicated, but it isn't.

Let's imagine the following situation:

The customer borrowed R$1,000 at an interest rate of R$3,100 per month.

In the first month: R$ 5,000.00 to 3% = R$ 5,150.00. That's R$ 150 in interest.
In the second month: R$ 5,150.00 to 3% = R$ 5,304.50 (R$ 154.50 in interest.

In this model, the repayment term makes all the difference. The longer the loan repayment period, the more interest will be paid.

Beyond interest

In addition to the well-known interest rates, it's important to pay attention to the Total Effective Cost (CET). Present in transactions such as loans and financing, the CET includes some administrative fees and financial charges that, in the final bill, can weigh heavily on your wallet.

IOF: the Tax on Financial Transactions is charged in cases of loans, financing, exchange transactions, etc.
TAC: although it is not a mandatory fee, the Credit Opening Fee is still charged by banks and financial institutions.
Administration Fee: like the previous example, this is not a mandatory fee, but may be charged when contracting the service.

How to get a loan with lower interest rates?

One aspect that can benefit customers is competition among financial institutions. Since they always strive to offer lower rates than their competitors, it's easy to find attractive deals.

How do you know which bank has the lowest interest rate?

When choosing which bank to choose, use technology to your advantage!

With the emergence and popularization of financial fintechs, the ease of obtaining an online loan with more advantageous conditions has also increased.

In addition to convenience and easier service, since these technology companies specializing in finance do not have physical branches – unlike traditional banks – the reduced operating costs end up resulting in lower interest rates.

Conclusion

The best way to get a good deal is to compare the interest rates each one offers.

Before making your decision, it's essential to put everything down on paper—or even on a financial spreadsheet, for the more tech-savvy—and evaluate whether the interest and other fees will actually fit within your budget.

Your wallet will thank you!