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How do interest rates affect a loan?

Find out everything you need to know about what interest rates are, what they mean for your borrowing and how they’re calculated.

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.

From repayment terms to credit scores, it’s vital you understand the most important aspects, so you know your way around the loan repayment process.

One of the most difficult to understand parts of the process can be interest rates. Although they’re a constant across all types of borrowing, interest rates are very rarely consistent. They can change massively depending on what kind of product you’re applying for, as well as your circumstances.

To understand what interest rates are, how your lender decides what interest rate to charge on your borrowing and what this means for your repayment terms, we’ve put together this helpful guide to rates and how they impact your borrowing.

What are interest rates?

Interest rates are essentially the fee you pay to borrow money, regardless of the product, 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 and are paid back as part of your repayment plan, increasing the total value of what you owe.

How do loan rates 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.

Interest rates differ depending on the type of borrowing you’re applying for too. For example, if you take out a personal loan, your interest is calculated at the outset of the loan and you pay a set monthly payment (including a portion of the interest) every month. However, for other types of finance such as credit cards, the interest you pay 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

The biggest factor interest rates affect is your repayment schedule. 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 payment.

Before applying for a loan, it’s worth checking the interest rate charged and how that 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 [1], the average loan interest rate is 9.41%. 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 and provide consistency to your borrowing.

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, the base interest rate, set by the Bank of England, impacts what lenders charge. Put simply, when the base rate rises, so too 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:

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:

If lenders feel one or more of those isn’t satisfactory, you may be offered a higher interest rate when borrowing to compensate.

How to calculate interest rates on a loan

Because of those external factors, borrowers can’t calculate interest rates on a loan. However, you can quickly determine how the interest rate you’re offered will affect monthly loan repayments.

Using a loan calculator, you can arrive at the final cost of your loan, which includes interest. Divide it by the number of months you’ve chosen to pay off the loan, and you’ll get an idea of the monthly repayments.

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, so to get better interest rates when you borrow, the most important thing is to ensure you improve your credit score.

This won’t be an overnight project, but it’s something you can work on to build up over time, improving your chances of getting a better rate of interest.

To improve your credit score, you can take some measures. A few simple steps include:

It’s also possible to find more favourable rates of interest without having to wait. The best way to do this is to shop around for the best deal.

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.

Find more tips on improving your credit score with this handy guide.


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