How Interest Rates Work When Borrowing

Finance > Banking 101

How Interest Rates Work When Borrowing

Borrowing money comes at a cost, whether for a credit card, loan or mortgage. This cost is known as interest and is usually displayed as an annual percentage.

Interest Rates

When borrowing money, you will be required to pay back the amount borrowed plus the interest. Interest is usually expressed as a percentage, known as the ‘interest rate’.

Example:

If you borrow £100 with an interest rate of 10% per annum, after one year, you will be required to pay back the original £100 plus £10 (10%) interest, totalling £110.

Annual Percentage Rate (APR)

Whilst the interest rate reflects the cost of borrowing the money, it isn’t quite the whole picture.

You may have seen the letters APR thrown around on loan adverts. APR stands for annual percentage rate and combines interest rates with any associated fees, e.g. annual fees.

For example, APR might be 18%, but this is made up of 16% interest plus fees, which equates to an additional 2%, giving you the total cost to borrow.

Due to APR taking into account both interest rate and associated fees, it gives you the cost of debt over a year. For this reason, it is the figure you should use to compare the annual cost of borrowing between lenders.

Representative APR

Representative APR is the rate that at least 51% of successful applicants for a loan must get (usually the advertised rate). The other 49% can get a different rate, which is generally higher. The rate you are actually offered based on your circumstances is called your Personal APR.

The lender can, of course, refuse your application to borrow altogether. So it’s worth checking your credit reports before doing an application.

Flat Interest Rate Loans

Flat rate loans mean you pay interest on the whole amount borrowed, for the duration of the loan, regardless of what you’ve paid back.

Flat rate loans are sometimes used as they can display a lower percentage, making the deal look more attractive than APR, which is usually higher. However, whilst it may look like a better deal, it’s not always the case.

Example:

If you borrow £10,000 and agree to a 5% flat rate over five years, you will pay 5% interest on the whole £10,000 for the entire five years, regardless of whether you pay back any of the loan.

5% of £10,000 = £500 per year

£1,500 x 5 years = £2,500 of total interest

On the other hand, APR only applies to the money you still owe, so whatever you pay off throughout the loan period is out of the picture.

Example:

If you borrow £10,000 and agree to a 7.5% APR over five years, if you decide to pay back £2,000 each year, you will only pay 7.5% on the outstanding debt.

Year 1 – 7.5% of £10,000 = £750

Year 2 – 7.5% of £8,000 = £600

Year 3 – 7.5% of £6,000 = £450

Year 4 – 7.5% of £4,000 = £300

Year 5 – 7.5% of £2,000 = £150

£750 + £600 + £450 + £300 + £150 = £2,250 of total interest

Although APR looked more expensive due to a higher percentage, it can work out cheaper once you have accounted for potential repayments.

Fixed Rate Interest vs Variable Rate Interest

The borrower gets a fixed interest percentage for the duration of the loan. The benefit here is that you can calculate the cost of your loan over the period due to the rate remaining constant.

The lender can increase or decrease the rate at any point within the loan period. This is usually in response to the bank rate.

Variable rates run the risk of increasing if the market changes but will also likely decrease if the bank rate falls.

Bank Rate:

The rate at which the central bank (Bank of England) charges other banks to borrow money.

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Finance > Banking 101