Most of us understand that when we take a loan, we need to pay interest. Interest is the amount you must pay to the lender on top of the amount originally borrowed, but how many people understand the various types of interest that can be charged? It can be very confusing so here is a quick and simple guide.

Annual Percentage Rate 

Annual Percentage Rate (APR) is the annual rate charged shown as a percentage that represents the costs you will repay on any credit product such as a mortgage, credit card, personal loan or a payday loan, etc over the period of one year. In the UK, it is a legal requirement that the APR must be shown clearly on all loans.

The APR is supposed to help the borrower to compare costs across a range of different products available however it can be a misleading indicator of actual costs, particularly when comparing products that are repaid more quickly or have shorter durations.

Fixed interest

Fixed interest means that interest rate on the loan you have taken out has an interest rate that does not change throughout the period of the loan. It means that you know exactly how much you will be paying for the loan every month. One of the advantages of this type of loan is that it helps you manage your finances more easily. Of course, the disadvantage is that if interest rates go down you will feel no benefit as your repayments will remain the same. Conversely of course, if interest rates rise you will be unaffected.

fixed-variable-interest-rates

Variable interest

Variable interest means that the rate can change with any fluctuations in the pound or financial markets. As can be seen in the past, world events or changes in government and trade can dramatically affect the interest rates – from the highs of the 1980s and 1990s to the current record low we see today. So, you need to think carefully before signing up to any agreement where the interest rate can fluctuate. Think of a worst-case scenario where rates go up – could you still afford to pay?

Compound interest

“Compound interest is the eighth wonder of the world”, Albert Einstein.

Compound interest is not quite as complicated as it may sound. To put it as simply as possible, it refers to interest paid on the original amount invested plus interest on top of that which has already been earned.

So, if you invest £100 in a compound interest account at a fixed rate of 5% per annum, the interest you will earn will be £5.00. That brings the total amount of your savings to £105.00. The following year, provided of course that you leave your money untouched, you will receive interest not on your original investment of £100,00, but on your new total savings balance of £105.00. So, at the end of the second year, you will receive interest of £5.25, bringing your total savings to £110.25.

So perhaps that is why Einstein referred to it as the ‘eighth wonder of the world’. It allows your money to grow without you making any further investment into it.

How to calculate interest 

Years ago, working out how much you were going to pay for a loan over any given period was quite a complicated and daunting prospect for some borrowers. Now, however, the use of online calculators has simplified the whole process. What used to be a troublesome and tiresome process can now be completed in a matter of seconds with a few clicks on a keyboard or taps on a phone.

Many loan companies and payday lenders have their own calculators, thus making the process even simpler.

How to search for the best deals with the most affordable interest rates

Loan comparison websites can be incredibly helpful in helping you find the most suitable kind of loans to meet your needs. They often have valuable information on a whole range of products that will help you decide what is right for you and allow you to check most of the current deals available.

Other considerations:

Low-interest rates are not the only thing you need to look out for, so please take into consideration the following factors:

Penalties

Some secured loan lenders charge penalties if you want to pay your loan back early. These effectively penalise people who can repay early because the lender is missing out on a sizeable chunk of interest.

Charges and late payments 

Several lenders make an administration or arrangement charge to set up a loan and others will penalise you for making late payments.

Your repayments may be variable

The rates on unsecured loans are usually fixed, but some secured loans have variable rates – so your repayments could rise. Make sure you know whether the rates are fixed or variable before you sign, otherwise you could get a shock if your lender suddenly hikes the rate.

You don’t have to buy PPI when you take out a loan

Payment Protection Insurance (PPI) is designed to cover the cost of loan and credit card payments if you are unable to work due to accident, sickness or unemployment. Many people wrongly assume that it must be bought from the same bank or building society they are borrowing from. It doesn’t. Nor does it have to be bought at the same time a loan is taken out.

A poor credit rating

Having a bad credit rating can mean that you may either be refused a loan or have to pay a higher rate. It’s always a good idea to check your credit rating on a regular basis to know where you stand.

Take your time and seek advice

If you need a short-term personal loan, consider your options first. For some people setting up an overdraft facility with your bank may be a good option but for others, a short-term loan may be the best solution. But whatever you do, please ensure that you deal with a reputable company that is authorised by the Financial Conduct Authority and ensure you can meet the repayments when they fall due.

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