How do interest rates work?
The interest rate set by a lender is normally non-negotiable and when you take out a credit card or apply for a loan then you are applying to borrow at that set rate. The interest rate is expressed as a percentage and this percentage represents the amount of the whole borrowing that you will pay – so, for example, if the rate is 10% for a year then over the course of that year you will pay 10% of the total amount you are borrowing in order to loan the money from the lender.
Using the percentage above as an example, if you borrow £1,000 for a year and the interest rate is 10% for 12 months then the borrowing will cost you around £100. If you borrow the money for just six months then you will pay approximately £50. These amounts can vary when taking account of ‘compound interest’ – this comes into play if you’re borrowing over a longer period of time and where you essentially end up paying interest on the original amount, plus the interest already accrued.
Short-term loans interest
When you borrow money as a short-term loan you will pay an amount in interest for that borrowing. This is often a set figure – for example, if you apply for payday loans, you will usually pay around £25 for every £100 that you borrow. The interest is calculated in advance when you make the application for the loan, which tends to make budgeting for the repayments much easier than making payments onto a credit card where the interest will depend on what the balance is on the card at the time the monthly payment is due.
Often, short-term loan interest rates are still expressed as an annual percentage rate (APR), in the same way as longer-term interest rates are. It is a legal requirement for lenders to display an APR on their websites, which is why you will see them no matter what the type of loan. However, these are not particularly helpful or accurate because with short-term loans the amount of money is borrowed for much less time and so the interest is not being compounded over the course of the year – it is better to look at the monthly interest rate for this type of loan.
Long-term loans interest
The interest rates on long-term loans can be much more variable than shorter-term loans and there are lots of different rates on offer depending on the lender that you choose to opt for.
It’s important to bear in mind that longer-term loans carry compound interest – as mentioned above this is essentially where you are paying interest on the interest already accrued on the original amount borrowed. By way of example, borrowing £1,000 for 20 years at a rate of 15% per year without making repayments would result in a debt of £16,400 where compound interest is included in the calculation. If you took away the compound interest element the interest would be just £4,000.
Where a monthly interest rate is being quoted for a long-term loan this often won’t take into account the compound interest element – for borrowings over a couple of months it’s always better to look at the APR.
Mortgage interest rates tend to be slightly different to the interest attracted by other types of borrowing. A mortgage is essentially just a large loan, borrowed to fund the price of a property. However, because of the size of the loan, the repayment period is much longer (usually 25+ years) and the loan will be secured on the property i.e. if the borrower defaults on the loan the property can be sold to repay the loan. Mortgages come in several types and the main differentiating factor between them is the interest:
- Standard variable interest – this is the lender’s standard interest rate. It generally moves in line with the rate of interest set by the Bank of England (the Bank of England Base Rate) but the lender is not obligated to pass on the benefits of any rate cuts,
- Tracker – this rate of interest exactly tracks the Bank of England Base Rate,
- Fixed rate – the interest on the mortgage is fixed for a period of time. This interest rate tends to be higher but there is less risk, as it won’t move,
- Discounted – this interest rate tracks the lender’s standard variable rate but at a discount below it (or a margin above it).
Credit card interest
When you apply for a credit card you will be given a credit limit and this represents the amount of money that you can ‘spend.’ Credit card interest is calculated on a monthly basis and if you use your credit card and then pay the balance off every month – i.e. clear the debt on the card before the interest is calculated – then you won’t pay any interest because there won’t be a balance to pay the interest on. If you don’t clear the balance then you will pay interest on whatever you owe the credit card company at the time. The exception to this is where you have signed up for an introductory offer that allows for a period of borrowing without any interest charged (‘interest-free’).
Interest on credit cards is calculated as an annual percentage rate (APR) – this is essentially the cost of borrowing and will include any upfront fees the lender might charge, spread over the length of the borrowing. You will normally pay the interest on your credit card balance as a monthly payment – this is incorporated into the calculation of the ‘minimum payment’ i.e. the minimum amount that you need to pay each month, which is worked out depending on the balance on the card.