How do interest rates work?

How do interest rates work?

Understand what interest is, why you pay it and why some rates are higher than others.

Here, we describe how interest rates work and what they mean for your loan.

What are interest rates?

Interest rates on loans are basically the amount you’re paying to borrow the money worked out as a percentage.

How interest rates are applied to a loan

When the cost of borrowing the particular amount you want is worked out, the cost is added as interest to the amount you’ve asked for. It’s shown as both a percentage and a lump sum of money. You’ll pay some of the total interest with every repayment.

What is APR?

APR stands for Annual Percentage Rate of Charge and was created as a way to help consumers compare the cost of borrowing of similar products. The APR includes not only how much the loan will cost i.e. interest, but also any other fees which will be added to the loan. This could include administration fees, broker fees, insurances etc. It is meant to give consumers an idea on the true cost of the loan.

At least 51% of people applying for a loan in response to an advertisement should get the APR rate advertised. To find out more about APRs, click here.

Why you’re charged interest

The interest charged by a lender is not simply the profit the lender hopes to make on any amount loaned. Unless the lender is a bank which is lending customers money already held with it in bank accounts, the lender will also be borrowing the money it relends through loans and will have to pay its own creditors interest. The lender also needs to make money to balance the costs of setting up in business, of maintaining the necessary staff, building, computer systems and credit administration systems etc in order to provide you with a loan.

Why are some interest rates higher than others?

The interest you are charged can be dependent on your credit rating and whether you’re seen as a reliable borrower, this is known as risk based pricing. If a borrower has a bad credit rating, this tells lenders it’s riskier to lend to that borrower as there’s a chance they won’t repay their loan. As we know, people with a bad credit rating may consequently find it difficult to get credit from some lenders.

Lenders who will accept customers with a bad credit rating will therefore have a higher interest rate as there is a greater risk involved in lending money to some of its customers.

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