What are the different types of loan interest?

Lenders lend money in order to make money from the interest that they charge. Should you borrow £1000 at an interest rate of 9% then you would have to pay £90 of interest, which means you'd pay back a total of £1090. That £90 covers costs and profit for the lender.

The interest rate itself is the amount of interest that you will be charged. Its size will affect what you will have to pay back to the lender. The example above illustrates this. Calling it an interest rate is too simplistic though. With loans the interest rate should be referred to as an APR - the Annual percentage Rate, which, even if the loan has a monthly interest rate, should be still shown.

Lenders use many tricks of the trade, and one of them is to show you the headline interest rate. This is the rate that the adverts will shout about. It could be anything, but the headline rate will not last for that long, so you may as well ignore it and compare loans using the APR. It is a legal requirement for lenders to show the APR, and you should ask any broker what the APR is on the loan you are being offered. They do not have the right to avoid that questions, and when they talk about the interest rate they should be referring to the APR.

The APR levels the playing field, as explained above. It enables you to make a true comparison between different loans. It takes all of the costs of the loan into account and was introduced by the government to prevent any nasty charges being hidden from the consumers. An example of this is that you could have a monthly interest rate of 1%, yet a yearly interest rate of 15%. This is more than 12 times the monthly charge. This is because the APR has to include the arrangement fee, any payment protection insurance, everything, but the monthly rate is basically a marketing tool. A common rule of thumb is that the lower the APR is on a loan, the better, as you will have less interest to repay.

You will also hear a bit about the "base rate". This is an interest rate reference point that is set by the Bank of England as a standard for people to use. Up until now, when you are considering a loan, its been the bit on the news which you've ignored, but you should pay attention from here forward. The lender will set a loan rate as higher than the base rate. So if the base rate is 4% and you are paying 2% above it then you will pay 6%.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

© AskFinancially.com 2008

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