If you’re applying for finance, whether it’s a secured or unsecured loan, credit card or a mortgage, there’s a lot of confusing terminology to get your head around. Find out what interest is and how to prepare for interest rate increases when borrowing.
From repayment terms to credit scores, it’s vital to understand the most important aspects of interest rates. Understanding what interest rates are can help you to know your way around the loan repayment process.
Although interest rates are a constant across all types of borrowing, they’re rarely consistent. They can change massively depending on what type of product you’re applying for, as well as your circumstances.
This helpful guide should help you to understand what interest rates are, how they’re determined and what a rise in interest rates could means for your repayment terms.
What you’ll learn –
- What are interest rates?
- How does interest on loans work?
- Repayments and interest rates
- What affects your interest rate?
- What causes inflation?
- How does inflation affect interest rates?
- How interest rates affect your loan
- How can I get a lower interest rate?
- How does the interest rate affect my mortgage?
- Tips to help you manage a mortgage interest rate rise
- FAQs
What are interest rates?
Interest rates are the fee you pay to borrow money, which is paid back over the duration of your borrowing period. They enable the lender to make money when they give you a loan, credit card or any other type of finance.
Interest rates are calculated as a percentage of the total value of your borrowing. They’re paid back as part of your repayment plan, which increases the total value of what you owe.
How does interest on loans work?
You’ll see the interest rate you’re being charged indicated as a percentage whenever you borrow money. This is usually presented as an annual percentage rate (APR), which shows the percentage of the loan value you will be charged by your lender every year.
Personal loan interest rates
Interest rates differ depending on the type of borrowing you’re applying for. For example, if you take out a personal loan, your interest is calculated at the outset of the loan. You pay a set monthly payment (including a portion of the interest) every month.
Credit card interest rates
For other types of finance, such as credit cards, the interest you pay is worked out differently. It will be worked out against the balance of your account at the time of your monthly statements. Therefore, it can differ depending on how much you owe.
Repayments and interest rates
When you borrow money, it’s not as simple as splitting the amount you owe into equal amounts over the agreed repayment term. Your lender will charge interest on how much you owe, which will increase your monthly payments.
Before applying for a loan, it’s worth checking the interest rate charged and how it will affect your total repayments. It’s important to consider whether you can afford to repay the money, as well as the interest owed on the borrowing.
According to research by Experian, the average loan interest rate is 10.16%. This may be a good figure to compare to when you’re searching for loans, so you have an idea of what you might be expected to pay, depending on your credit score and financial history.
Another consideration is whether your interest levels are a fixed rate. If they are fixed with the lender, your repayments will remain the same throughout your loan, allowing you to budget for what you owe.
However, if the rates are variable, your repayments may go up if the base rate rises. It’s worth considering what impact this could have and making sure you can still afford repayments in the event your interest rates change.
What affects your interest rate?
When it comes to borrowing money, interest rates rely on several factors, some personal to you and others economical. For example, a rise in the base interest rate, set by the Bank of England (BoE), impacts what lenders charge. Put simply, if the base rate rises, so does the cost of borrowing.
On a personal level, your circumstances will determine how much interest you pay on loans and other forms of borrowing. Your credit rating is the primary factor here, but there are also other things to consider, including your:
- Current earnings
- Employment status
- Existing levels of debt
All of these things are carefully considered by lenders, who will weigh up how much of a risk lending to you represents. Lenders determine your risk based on things like your:
- Employment history
- Track record of borrowing
- Current credit score
What causes inflation?
Inflation is caused by an increase in the costs for everyday goods and services. This means if the UK’s annual inflation rate rises by 2%, on average, the price of your shopping will be 2% higher than it was last year.
This rate is calculated by the Office for National Statistics (ONS) by looking at how certain goods and services, such as furniture and household items, have influenced the overall Consumer Prices Index.
Sometimes, you can face higher costs than the UK’s inflation rate on a particular service, such as train tickets, if there’s an increase in demand.
How does inflation affect interest rates?
The relationship between interest rate and inflation is interchanging, meaning when one rises, the other will usually fall.
The Bank of England base rate is set up to purposely help keep the UK’s inflation target of 2%.
When interest rates decrease, there’s an increase in borrowing. This means people have more money to spend on the economy, subsequently causing inflation to rise.
Additionally, if the economy is growing at a rapid rate, the bank may increase their base rates to slow spending and keep inflation down.
If the Bank of England predicts this 2% inflation target can be met without interference, the bank’s interest rate will remain unchanged.
How interest rates affect your loan
Fixed rate loan
If you already have a fixed rate loan, an increase in interest rates shouldn’t affect your monthly repayments. This is because the total amount you will pay back, known as the Annual Percentage Rate (APR), is calculated before you take out a loan.
This means throughout your loan term, the percentage of interest you pay back will stay the same. This can be both positive – if the bank rate increases, your repayments won’t go up. On the other hand, if the rate lowers, you won’t be able to save on your monthly payments.
The only time you may be affected by a rise in interest rates is if your interest rate is variable, which could be the case on your mortgage. When your fixed interest rate on your mortgage comes to an end, you’ll automatically switch to a Standard Variable Rate (SVR). This default rate can then fluctuate depending on inflation and the bank’s base rates.
When taking out a loan, check your terms to see if you could be affected by inflation through variable interest rates. With Norton Finance, we search the market to find you a suitable repayment plan for your circumstances. Explore our range of loan products today.
How can I get a lower interest rate?
The lowest and most favourable interest rates are typically reserved for those who have a strong credit score.
Improving your credit score could help you to get lower interest rates when you borrow. This won’t be an overnight project, but it’s something you can work on to build up over time.
A few simple measures that may improve your credit score include:
- Ensuring your address and personal details are up to date
- Always making payments on your existing debts promptly
- Keeping your total debt low in comparison to the credit limit you have (on credit cards, for example)
It’s also possible to find more favourable rates of interest without having to wait. While it’s true that your circumstances are the main factor in deciding your interest rates, some lenders will offer more favourable terms than others, so it can pay to take time to find the best deal for you by shopping around for the best rates.
How does the interest rate affect my mortgage?
When the BoE raises the base rate, interest rates will go up. Savers will rejoice as it means a better rate on their accounts. But borrowers want as low an interest rate as possible, in order to make lower repayments on their mortgages.
An interest rate rise affects mortgages differently and depends on your own circumstances – for more information on mortgages and associated terms, check our mortgage jargon buster.
If you have a fixed rate mortgage
Fixed-rate mortgages mean that you have a fixed interest rate for a set period, usually two or five years (however there are some 30-year fixed-rate mortgages on the market). Customers with fixed-rate mortgages won’t be impacted by the predicted increase in interest rates – unless their fixed-rate mortgage deal is coming to an end.
If you have a fixed-rate mortgage, you may want to switch mortgages sooner rather than later to take advantage of the low-interest rates before they begin to climb. Switching mortgages when you’re not moving home isn’t as complex as you might think and could save you thousands over the course of your loan.
Early repayment charges are a concern, but if you’ve only got a few months left on your fixed rate, the timing could be perfect.
If you have a standard variable rate, or a tracker mortgage
Most homeowners have a standard variable rate mortgage or tracker mortgage. These mortgage types are likely to be affected by the impending interest rate rise. Rates adjust along with the BoE base rate, so you can’t be certain of future rises and falls.
If the BoE’s base interest rate gradually rises, those with variable-rate mortgages could be in for a shock. One answer may be to bite the bullet, pay the earlier repayment fees and re-mortgage now on a fixed rate before the slow rise gets underway.
Tips to help you manage a mortgage interest rate rise
There are a few ways to help manage your mortgage if interest rates rise.
Establish what mortgage type you have
If, for example, you have a five-year fixed-rate mortgage with three years remaining, a rise won’t impact you right now. Establishing what type of mortgage you have allows you to work out how a rise in rates will affect you.
Work out how much you can afford
If you already struggle to make your mortgage payments and are concerned about whether or not you’ll be able to pay them if there is a rise in the interest rate, you can prepare in advance before that day comes.
Build your credit score
By working on your credit score you can help set a great foundation to get a better deal if you remortgage or if your term is about to end on a fixed-rate mortgage.
Overpay where possible
If you’re not expecting an interest rise anytime soon, you can take advantage of the low rate you currently have by paying a little extra towards your mortgage – if your lender allows it.
There are limits on how much you can overpay in a year and in some cases, there may be charges. Be sure to check with your mortgage provider before you start overpaying.
As a leading provider of financial information, Norton Finance can give you the support and guidance you need, no matter what type of mortgage you’re paying.
FAQs
What happens when interest rates rise?
Rising interest rates generally mean that businesses and consumers will reduce their overall spending and borrowing will become more costly. Typically, a rise in interest rates is in response to rising or high inflation – this is to encourage people save more as well as borrow and spend less. This has the intended outcome of reducing inflation by slowing the economy.
What is a normal interest rate for a car loan?
As of Q3 of 2022, the average car loan interest rate is around 6.07% for a new car loan and 10.26% for a used car loan. As these are average numbers, your personal interest rate be higher or lower than the average, depending on your financial circumstances and individual borrowing terms.
Can I fix my mortgage for 5 years?
Yes. As interest rates and inflation change often, choosing a fixed rate mortgage means you will pay the same monthly amount for a set number of years. Usually, you can choose two or five years for fixed-rate mortgages. Once five years are up, you will adapt your lender’s standard variable rate (SVR).
Find out more tips on improving your credit score with this handy guide.
Share:
