What is Interest on a Loan?

Understanding Loan Interest

Interest on a loan is the price you pay to use someone else’s money.

Think of money as fruit on a tree.

You can do two things with the fruit:

• You can eat it,
• You can sell it.

For the borrower who eats the fruit, interest on a loan is the cost of using someone else’s money.

For the lender who sells the fruit, interest is the fruit on their money tree.

Borrowers eat the fruit by using the money. Lenders sell the fruit and get paid interest.

Banks and other loan companies have funds which borrowers need to buy something.

Lenders cannot offer their money for free; their capital must be productive and work for them or it will lose its buying power due to inflation. Inflation means the buying power of money becomes less.

We say the money can buy less than last year or, put the other way, prices have increased since last year. If your money buys less because the prices are higher, you know that there is inflation.

In South Africa, interest rates on various loans differ, depending on the lender and the specific loan type.

Loan interest rates are given as a part of the total loan amount such as 5%. meaning 5% of the loan amount or R5 for every R100.

The interest rate you pay depends on your credit history, for how long you want to borrow the money, and the type of loan. For instance, short-duration loans often have higher rates compared to longer-term loans. The long term loan has less risk for the lender so the interest is lower.

At the time this article is published, interest rates in South Africa are between 7% and 35%.

You need to evaluate these rates before entering into a loan agreement, as higher rates make the cost pf the loan higher. Borrowers must be keep on mind any fees or penalties that might come with the loan, such as generation fees or fines for early settlement.

Knowing the cost of borrowing money enables borrowers to make good decisions and select a loan that they can afford.

The Mechanics of Interest

Interest is calculated as a percentage of the loan amount also known as the principal amount.

Internationally, including in South Africa, rates may vary based upon the borrower’s credit rating, the nature of the lending agreement, and the time over which the loan is to be repaid.

To illustrate, a borrower who takes up a loan of R10,000 at an annual rate of 10% would have to repay R11,000 after a year. After one month, the borrower would need to repay R10,083.33.

Categories of Interest

Interest can take two primary forms: simple and compound.

Simple interest is only calculated on the initial loan amount and does not account for any other interest.

Compound interest includes both the loan amount and any build-up of interest over time.

Compound interest is much more expensive than simple interest because you pay interest on top of interest.

• Simple Interest:
  • Calculated on the loan amount
  • Does not compound (interest on top of old interest)
  • Formula: Principal x interest rate x time (R1000 loan amount x 10% interest x 1 year = R100,00 interest)
• Compound Interest:
  • Calculated on loan amount plus previous interest
  • Grows over time because you pay interest on old interest
  • Much more expensive than simple interest

Most short term loans available in South Africa pay compound interest.

You need to understand the loan agreement so you know what interest rate you pay, what the repayment terms are, and what other charges there are.

It is also wise to compare loans to get the best interest rate.

Understanding interest is very important as they influence the amount you will eventually have to pay back to the lender.

Interest Charges and Borrowing Expenses

Factors Influencing Interest Rates

In South Africa, financial institutions employ various strategies to set interest rates.

Interest rates are usually based on the prime lending rate, which is the cost at which banks provide funds to their most trustworthy (less risky) customers.

Loan companies add an additional percentage to this prime rate, based on the borrower’s risk profile such as your credit score.

Working Out Loan Payments

The total repayment amount (loan plus interest) on a cash loan is influenced by the interest.

Calculators for loan repayments take into account the principal amount, interest rate, and term of the loan, offering a clear view of the monthly instalments.

Example: borrowing R10,000 at an interest rate of 15% over one year results in monthly instalments of R917.67, whereas at 20%, the installments rise to R954.83.

Results of Interest on Borrowing

Interest rates influence the overall cost of borrowing money.

Higher interest rates increase the regular repayment amounts, making it more difficult to repay a loan and attracting extra fees.

On the other side, lower interest rates make loans more affordable.

As loan costs differ widely, it is wise for borrowers to compare the various lenders to make sure they take the best loan for their budget and also makes it less risky because they can afford to repay the loan.

Repaying your loans on time increases your credit score, and can let you qualify for lower interest rates in the future because you are a lower risk borrower.