How are loan interest rates calculated?

How are loan interest rates calculated?

author: Bryony Pearce

By Bryony Pearce

Not sure why you’re being given a certain interest rate? In this blog, we’ve explained the calculations behind the numbers, along with how to keep them down.

In their simplest form, interest rates are the cost of borrowing money. When you take out any type of loan – whether it be personal, secured, payday or other – you’ll be charged interest on the amount you borrow. This is one of the main ways lenders make their money.

What impacts interest rates?

There’s no such thing as a one-size-fits-all approach when it comes to interest rates, and there are a number of factors that contribute to the percentage you’re given, such as:

Your credit history

If you have a poor credit history, you could be given a higher interest rate than those with a good credit history. This is because you’re seen as a greater risk to lenders, so they balance out that risk with higher rates.

There are a number of things that can lead to a poor credit history, but some of the main drivers include missed or late credit repayments, bankruptcies, debt management plans or County Court Judgements (CCJs) against your name, not being on the electoral roll, and attaching your finances to someone who has a bad credit history.

Similar to a poor credit history, a non-existent credit history can impact the interest rate you’re given on a loan too. Seems unfair if future lenders have no reason to doubt your reliability, right? Although this might be true, a non-existent credit history doesn’t give lenders any indication as to the type of borrower you are – which doesn’t exactly fill them with confidence and can lead to higher interest rate offers.

The type of loan

You may find the interest rate varies depending on the type of loan you apply for, even if you’re requesting the same amount. Using personal and secured loans as an example, the lender has more security with the latter because you’re required to put up some form of collateral – usually your home – against the loan.

This collateral gives the lender peace of mind that they can retrieve the money they lent you (should you be unable to repay it in full), and this reassurance can contribute to lower interest rates.

The economy

Although there’s nothing you can do to influence this one, it’s still an interest rate factor and so we didn’t want to brush over it.

You may find that interest rates offered by lenders are more attractive during times when the economic climate is slow, and this is because banks and the government want to promote spending to boost the economy. This might not be much use to you if you’re looking for a loan while the economy’s thriving, but it’s perhaps one to bear in mind if you can wait.

Calculating interest rates

When it comes to the maths side of calculating how much interest rate you’ll pay on your loan, things can get tricky. Fortunately though, there is a whole load of calculators out there to take care of the number crunching for you. In fact, we have our very own loan calculator that you can use for free.

It’s really important that you take the time to calculate how much interest you’ll pay on a loan before you take it out, to ensure that you’re confident in your ability to repay it.

For example, if you take out a £5,000 loan over three years and it has 22% APR attached to it, the total amount repayable would be around £6900. Therefore, you’re charged £1,900 in interest for simply taking out the loan – which adds a chunky sum to the overall cost and will be reflected in your monthly repayments.

How to find the best interest rate

1. Research. Research. Research.

If you want to bag the best deal, you may want to spend some time shopping around and comparing what’s out there. Don’t make any hasty decisions and don’t limit yourself to one lender. Cast your net afar (so long as it doesn’t go into choppy water!) and be prepared to put in the hours.

2. Improve your credit history

If your credit history is holding you back from securing a more competitive interest rate and you don’t need to access funds right away, take a step back, work on improving your credit rating, and then start looking again in a few months’ time.

3. Go back to your current lender

If you’ve currently got credit, debit and savings cards, for example, with the same provider, but their loan deals aren’t as good as others out there, it might be worth presenting them with what you’ve found to see if they’ll match or better the deals to keep your custom.

We hope you’ve found this blog useful in your pursuit of the best interest rate for your next loan. For more insights on all things interest-related, check out our dedicated blog page on it here.

Disclaimer: All information and links are correct at the time of publishing.

author: Bryony Pearce

By Bryony Pearce

How are loan interest rates calculated? How are loan interest rates calculated?