Understanding Interest When You Borrow Money
On Wednesday, March 25, 2020 -
Interest – it’s not the easiest thing to get your head around is it? There are different types and different amounts… so what does it all mean!? If your head is a bit scrambled with it all, don’t worry, you’re not alone. Apparently, over 50% of Brits don’t know exactly what it means either! So, let’s get this cracked once and for all.
We’re going to go through everything without all the complicated jargon so you’ll fully understand what you’re dealing with by the end of this article. And most importantly, you might be able to save yourself some money when next taking out credit. What a win!
Firstly, what is an interest rate?
This is the easy bit. When you borrow money from a financial organisation – whether in the form of a credit card, loan, mortgage or other – they don’t usually allow you to do so for free. That’s what the interest rate represents: it’s what they are charging you to borrow that money. Therefore, you will have to pay back the full amount that you originally borrowed plus more in interest. An interest rate is usually shown as a percentage of the amount you borrow, for example: 18% APR.
Another really common question when talking interest rates is ‘what does APR mean?’, so let’s also clear this up before moving on. APR stands for annual percentage rate and includes the interest rate you’re charged and any fees you pay, per year, for taking out credit, Therefore, the higher this number, the more you’ll have to pay back in total. Similarly, as it’s calculated on an annual basis, the longer you take to pay back the credit, the more you’ll have to pay back overall.
Let’s delve a little deeper…
Different types of interest
This is where it gets a little trickier to understand. There are a few types of interest that we need to get our head around – so now could be a good time to grab a brew!
There’s simple interest and compound interest, and also fixed interest and variable interest. We’ll get cracking and work through them together.
Simple interest
This is one of the more straightforward types of interest to explain. Simple interest affects HOW interest is applied to your loan.
Simple interest is only calculated on the amount of credit you borrow. So, lets say you get a £1,000 loan, interest is only calculated on that £1,000.
If the loan came with an APR of 10% and you took the loan out over one year, you would need to pay back £100 in interest. Quite straight forward, right?
Compound interest
Bear with us – compound interest gets a little more confusing. Like simple interest, this also affects HOW interest is applied and calculated on forms of credit.
Pretend that you have a credit card with £1,000 outstanding on it. With compound interest, interest will be added based on the original amount (the £1,000) and any added interest. So what we’re saying is that you could be paying interest ON INTEREST as the debt grows.
It might only seem like a small difference from simple interest but it can end up costing you a heck of a load more if you’re not careful. The table below shows the effect that compound interest could have versus simple interest over a five-year period with an APR of 15%, assuming you don’t pay any of the debt back.
Example of simple interest |
||
Year |
Debt amount interest is calculated based upon |
Total amount repayable after each year |
1 |
1000 |
1150 |
2 |
1000 |
1300 |
3 |
1000 |
1450 |
4 |
1000 |
1600 |
5 |
1000 |
1750 |
Example of compound interest |
||
Year |
Debt amount interest is calculated based upon |
Total amount repayable after each year |
1 |
1000 |
1150 |
2 |
1150 |
1322.50 |
3 |
1322.50 |
1520.87 |
4 |
1520.87 |
1749 |
5 |
1749 |
2011.35 |
Adds up, right? That’s why if you borrow money on a credit card that charges compound interest, it’s always best to pay back as much of your balance as you can every month to keep the interest costs down.
Fixed interest
As you could probably guess by the name, a fixed interest rate is a specific amount that won’t change for a fixed period of time. That could be the whole life of the loan, or just part of it. This type of interest rate is predictable; it’s easy to understand; it’s reliable; it doesn’t waver; it’s steady throughout… it’s like your best mate.
The biggest benefit of this type of interest rate is that there are no nasty surprises. You can work out your finances for the whole term and know that your repayment amounts will not change. Bliss.
Fixed interest rates can be found on various financial products, such as some mortgages – although only ever for a fixed amount of time – loans, and car finance. So, make sure you read and understand the terms before applying.
Variable interest
Now, variable interest… this is a bit more like that flakey friend. Things could change!
Even though you took out a financial product at the stated interest rate, it can still change at any time. The lender holds the power to increase the rate… but also decrease the rate, if they’re feeling so inclined. This means that your repayment amounts could change, which could affect how much money you’re left with in your bank account.
Variable interest rates can come with many financial products too, like loans and credit cards. Loan companies do have to tell you if they’re planning to change your interest rate, and give you plenty of notice. But it’s still worth keeping your wits about you if applying for credit with this type of interest rate.
What interest rate will I get?
The actual rate you’re offered by the lender all comes down to what your credit score is and what you can comfortably afford to pay back. If your credit score isn’t looking too happy, you could be given a higher APR than the one advertised. However, if you’ve got a high credit score, you’ll receive the best rates available from the lender, which means less to pay back overall when you take out finance.
Think your credit score might need a look? It could be worthwhile checking your credit report and correcting any mistakes before making a credit application.
OK, how you doing!? Head not too boggled? It’s great you’ve decided to get clued up because understanding how interest works can actually help you save money! We hope this article has made everything a bit clearer for you. If and when you next decide to take out credit, you’ll hopefully have the upper hand.