when the borrower is considered to be low risk by the lender the borrower will usually be charged a lower interest rate if the borrower is considered high risk the interest rate that they are charged will be higher which results in a higher cost loan 
risk is typically assessed when a lender looks at a potential borrower s credit score which is why it s important to have an excellent one if you want to qualify for the best loans simple interest rateif you take out a 300 000 loan from the bank and the loan agreement stipulates that the interest rate on the loan is 4 simple interest this means that you will have to pay the bank the original loan amount of 300 000 4 x 300 000 300 000 12 000 312 000 the example above was calculated based on the annual simple interest formula which is the individual who took out the loan will have to pay 12 000 in interest at the end of the year assuming it was only a one year lending agreement if the loan was a 30 year mortgage the interest payment will be simple interest 300 000 x 4 x 30 360 000a simple interest rate of 4 annually translates into an annual interest payment of 12 000 after 30 years the borrower would have made 12 000 x 30 years 360 000 in interest payments which explains how banks make money through loans mortgages and other types of lending compound interest ratesome lenders prefer the compound interest method which means that the borrower pays even more in interest compound interest also called interest on interest is applied both to the principal and also to the accumulated interest made during previous periods the bank assumes that at the end of the first year the borrower owes the principal plus interest for that year the bank also assumes that at the end of the second year the borrower owes the principal plus the interest for the first year plus the interest on interest for the first year the interest owed when compounding is higher than the interest owed using the simple interest method the interest is charged monthly on the principal including accrued interest from the previous months for shorter time frames the calculation of interest will be similar for both methods as the lending time increases however the disparity between the two types of interest calculations grows using the example above at the end of 30 years the total owed in interest is almost 673 019 on a 300 000 loan with a 4 interest rate the following formula can be used to calculate compound interest let s look at another example ben takes out a three year loan of 10 000 at an interest rate of 5 which compounds annually in the end as worked out in the calculation below he pays 1 576 25 in interest on the loan compound interest and savings accounts