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What Is an Interest Rate?

Lending companies are allowed by law to earn from their business by charging people who borrow money from these companies a fee for the service these companies offer, which is to lend money. Usually, lending companies earn money by imposing interest on the amount borrowed. The amount of interest put into the loan is called the interest rate.

Oftentimes, the interest rate of a particular loan is calculated based on an annual figure. This is imposed even when the terms of a particular loan stipulates for a different schedule for paying back the loan. For example, car loans often have a 3.5 percent annual percentage rate or APR. This is stipulated even if the actual repayment of the loan is spread over a duration of five years. What this means is that for every $1000 that was given as a loan, the borrower will have to pay the lending company an additional $29 in interest payments. The amount is then added to the monthly installment payments. By putting the interest rate as an annual percentage, it becomes easier to find out if the terms of one lending company is better than the offer of another company.

Interest rates come in two types – flexible or fixed. A flexible interest rate means the lending company will base the interest rate on the present federal interest rates, otherwise known as the prime lending rate. This means the interest rate will fluctuate based on the changes in certain economic indicators like inflation. A fixed interest rate means that the lending company will impose a certain interest rate and it will remain unchanged for the duration of the payment period until the whole loan has been paid back.

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