Interest is a term that is widely used in the finance industry.

With products like loans, credit cards and mortgages you’ll be charged interest. Whereas on savings accounts and current accounts you’ll earn interest.

In simple terms, interest if a fee that is charged to borrowers for the right to use the borrowed funds.

Interest charges are typically expressed as an annual percentage rate or APR. Interest is usually paid alongside the regular monthly payments.

An example of interest in practice

If you were to borrow £1000 over 12 months and pay no interest, you’d simply make 12 equal repayments of £83.33.

If, however that £1000 over 12 months was borrowed at an APR of 10%, you’d pay an additional £54.99 in interest. This would make the monthly repayments £87.92. The total repayment amount would therefore be £1,054.99.

How interest is calculated

At first glance, the calculations may be tough to digest.

One would assume that if you were being charged 10% interest on £1000, that would make the total repayment amount £1,100. Then surely the monthly repayments would be £91.66 (1100/12), right? Not quite.

See, interest is charged on the outstanding balance of the loan. Therefore, as you start to chip away at the balance, the amount of interest you’re paying decreases.

The table below illustrates this:

Month Balance Interest Payment
1 £1,000.00 £8.33 £87.92
2 £920.42 £7.67 £87.92
3 £840.17 £7.00 £87.92
4 £759.26 £6.33 £87.92
5 £677.67 £5.65 £87.92
6 £595.40 £4.96 £87.92
7 £512.45 £4.26 £87.92
8 £428.80 £3.57 £87.92
9 £344.46 £2.87 £87.92
10 £259.41 £2.16 £87.92
11 £173.66 £1.45 £87.92
12 £87.19 £0.73 £87.92

If you add up all of the interest payments in column three, you will be given a total of £54.99.

When calculating the repayments of the loan, you use the following formula:

(Amount Borrowed + Total Interest) / Loan term

Why do interest rates vary on loans?

You’ll probably notice that not all loans have the same interest rates. In-fact, some rates are significantly higher than others.

The lowest rate high street lenders will advertise interest rates of around 3%, whilst bad credit lenders will charge 50%+.

Whilst there are several factors that influence interest rates on loans, they are largely dictated by the risk to the lender.

Lending to someone with a spotless credit history carries minimal risk to the lender. Whereas lending to someone with a poor credit history carries a high risk. The rates must reflect this.

Bluntly put, a lender would quickly go out of business if they were lending to customers with a poor credit history at low rates

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