Interested in talking about interest? Whether it’s the revolving debt on a credit card or the lump sum of a personal loan, interest, and how it's calculated, is a very important factor to consider for consumers. Fortunately, when applying for a card or loan, all of that detailed information is readily available.
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Is Interest the Same for Credit Cards and Personal Loans?
In many ways, they are not. The easiest way to discern the two is to understand the difference between simple interest, which applies to personal loans, and compound interest, which applies to credit cards.
Simple interest is as simple as it sounds. It is a percentage predetermined by the lender that factors both the principal amount borrowed and the length of the repayment period. (The formula is: principal amount multiplied by the predetermined rate, multiplied by the number of years to repay.) Compound interest, on the other hand, is a percentage initially levied on the balance of a credit card, that is then compounded on a recurring, daily basis. In other words, it is interest on interest.
Furthermore, personal loans and credit cards are paid off in different ways, adding more nuance to the comparison beyond “simple interest vs. compound interest.” Here is a broader understanding of how interest works on both.
Personal Loan Interest
When an applicant is approved for a loan, a lender will provide a repayment plan that includes monthly installments over the term (or length) of the loan. For most personal loans, the interest plus other costs and fees are calculated as the annual percentage rate (APR), which is applied to the principal loan amount to produce the total amount the borrower pays back the lender. That total amount is then broken up into monthly payments over the loan term, which can range from 24 to 84 months.
Most personal loan APRs are fixed, meaning the predetermined rate does not change over the life of the loan, resulting in predictable monthly installments if they are paid on time. Additionally, borrowers benefit from having the interest calculated and applied just once, based on the principal, at the onset of the loan process.
Credit Card Interest
First and foremost, there is one huge difference with credit card interest, compared to personal loan interest—it doesn’t have to be paid at all. As long as a cardholder pays their entire monthly credit card balance on time, they will not be charged any interest on their account balance. Technically, interest is calculated and charged to the account balance on a daily basis, but those charges are waived as long as the entire statement balance is paid by the due date.
However, if a cardholder does not pay their balance in full between the statement closing date and due date (known as the grace period), the compounding interest will not be waived from their account balance. Once this occurs, a cardholder would need to pay their entire balance in full to prevent paying any further interest.
It’s also important to know that APR on a credit card only accounts for compound interest, not any additional costs and fees. Many cards offer introductory APRs, as low as 0%, which allow cardholders to not carry any month-to-month interest during the introductory period, which can last up to a year. However, any unpaid account balance after the promotion is over will be subjected to compound interest.
Personal loans and credit cards are typically used for different reasons, and as a result, interest works very differently on both. It’s important to know all the specifics, as far how the rate is predetermined, where costs and fees are hidden and what the consequences are for not paying a monthly bill on time. With Fiona, consumers can get matched with a credit card or personal loan offer that meets their needs.