What you need to know about loan interest rates
06.04.2020 by Dimi V
What you need to know about loan interest rates
When you are applying for a loan, one of the main factors that you need to consider is the interest rates that are offered. From logbook loans to payday loans; different rates are offered per lender and per loan type. Therefore, it is critical to understand how interest rates work so you can make sure the loan is affordable for you. With that being said, continue reading to discover everything that you need to know below.
What is an interest rate?
Interest is the cost of borrowing money that is typically expressed as a yearly percentage of the loan. Interest rates are not only applied to loans. They can be on savings accounts as well. For savers, this is essentially going to be the rate your building society or bank is going to pay you for borrowing your money. The money earned on your savings is known as interest.
Interest charged on a loan
When you borrow money, whether this a loan against a car or an unsecured loan, you are, of course, going to pay back the original loan amount. This is known as the capital. On top of this, you are going to need to pay back interest. For example, if you were to borrow £2,000 from your bank, and the yearly interest rate was 10 per cent, you would need to pay back £2,000 and then you would also need to pay back £200 in interest. So, in total, the amount you owe is £2,200. The amount you pay could be more or less depending on how long you borrow the money for.
What are the different types of interest rates?
There are a number of different types of interest rates - just to make matters confusing! These interest rates impact customers in a number of different ways. This depends on the full amount that is being borrowed. One thing that you do need to consider is that not all interest rates are calculated in the same way. Because of this, it is critical that you conduct your own research on every lender. So, let’s take a look at the different types of interest rates…
- Prime interest rate - This is the interest amount that the vast majority of commercial lenders charge to their most favoured and creditworthy customers.
- Variable interest rate - Interest rates fluctuate. They fall and they rise. A variable interest is one that can change throughout the duration of your loan.
- Fixed interest rate - This is the opposite of a variable interest rate. This is a stable rate that makes certain that consumers understand exactly how much they are going to have to pay every month. This ensures that you are able to manage your money effectively, as you know how much you’re going to be paying. However, it is worth noting that some lenders offer loans that are fixed for a period of time, for example, three years, and then they move onto being variable for the rest of the loan period.
- Compound interest rate - Typically, the compound rate of interest is calculated on a yearly basis. Interest and principal are the key components of the loan and they are used to determine the total amount of the year’s interest.
What factors impact your interest rate?
When it comes to the interest rate you are offered, there are a number of different factors that are taken into account. Some of these factors are out of your control, such as inflation and supply and demand. However, there are then factors that are linked to your financial activity and history. So, let’s delve a bit deeper!
Factors that are out of your control
Let’s begin by taking a look at the different factors that are out of your control. Firstly, we have inflation. This is a term that is used to describe when the prices of services and products increase, which lowers the purchasing power that currency has. Inflation can be good for people who carry debt, as it lowers the value of each pound you owe. However, at the same time, it is bad news for lenders, as the money they receive has a lower value. Because of this, inflation ends up increasing interest rates to account for the difference.
Another factor that is out of your control is supply and demand. When you think of interest rates, they are essentially the price of borrowing money, right? You pay back the amount you owe, and you then pay back a ‘fee’ for borrowing that money - the interest rate. Therefore, it makes sense that supply and demand have an influence on this. If there is an increase in the demand for money, or there is a decrease in the supply of money that the lender has, this can result in the interest rates increasing. On the flip side, if there is a lot of supply yet there is a low level of demand, interest rates may decrease.
Factors that are in your control
There are a number of factors that are in your control that will impact the interest rates you are offered. This is generally based on how much of a risk you are viewed in the eyes of the lender. First and foremost, whether or not you can offer a guarantee will be considered. A guarantee is essentially a way that the debt can be settled should you default on your payments. For example, this could be that someone else offers to be your guarantor and they will make the payments if you are not able to. Alternatively, if you opt for a loan secured against your vehicle, the car is going to be your guarantee. As there is a back-up in place, so to speak, the lender may be willing to offer you a lower interest rate because you are viewed as less of a risk.
Another factor that should be considered is the loan amount and the length of time you wish to lend the money for. While it may seem unfair that a longer repayment term or requesting a big sum of money can raise your interest rate, they can both make a loan more challenging to pay back. Because of this, you’re viewed as more of a risk. After all, a longer loan means you are going to be paying back money for longer. Moreover, a bigger loan means that your monthly repayments are going to be higher. Because of this, the lender will want to reduce their risk by increasing the interest rate. Plus, there is also an increased chance that you are going to come across some challenges in your life that could have a negative impact on your ability to pay back the money you owe. This is why interest rates will be higher.
Aside from the factors that have been discussed, your credit score is another influencing factor that is in your control. Your credit score will have an impact on many different parts of your life. Nevertheless, the most obvious is your ability to easily get credit. Since credit scores are meant to be a representation of your creditworthiness, lenders will look at your credit scores intensively and your credit history will be assessed to figure out how risk you are to lend to. High credit scores, which you are able to get by paying bills on time and keeping your use of credit low, will indicate that you are good at paying your debts off, and so this means the risk of lending to you is low. If you do not have a good credit score, though, the lender is going to view you as more of a risk. It is likely that they could reject your application altogether. If they don’t, then they will almost certainly increase your interest rate.
It’s not all doom and gloom if you have a poor credit score, though, as you can increase your score and there are a number of different ways you can do this. First of all, one of the easiest ways to go about this is by registering your name on the electoral roll. This won’t take long, and you will instantly get a boost. Aside from this, you should make sure that you do not apply for any new credit, as new applications will impact your score for six months. You also need to make every effort you can to pay off the money you owe so that you can reduce your debts. This is the best way to improve your score. After all, if you are currently using 60 per cent of your credit and you manage to get this down to 20 per cent, your score will increase considerably.
Hopefully, you now have a better understanding of what loan interest rates are and how they can impact the total amount of money you need to repay on your loan. This is something that you need to consider carefully when you take out any type of loan, including car equity release, payday loans, and any other type of loan.