How Does Interest Work?


Quick Answer

Interest is the fee that a person pays for taking out a loan, according to DebtHelp.com. The interest is determined by the interest rate as a percentage of the debt. Although interest rates can vary, the interest amount is added to the total loan.

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Full Answer

To calculate flat rate interest, or simple interest, the loan amount, or the principal, is multiplied with the interest rate and life of the loan. A loan for $5000, for example, with a fixed interest rate of 5 percent for five years adds a total interest of $1250 to the loan. That interest is then added to the original loan of $5000, but fees and other interest can increase the loan significantly, states DebtHelp.com. Compound interest is more common than simple interest. This type of interest can increase a loan amount quickly because the interest that is added to the loan also has interest.

In general, interest is added to the monthly payment, and the consumer's payment goes to the interest and the principal, according to About.com. Some loans allow consumers to pay more into the principal to decrease the total interest at the end of the loan period. Lenders determine interest rates by looking at the consumer's credit score and credit report.

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