How do banks calculate interest?
Most banks’ and financial institutions’ interest rates are influenced by the Bank of England Base Rate, set by the Bank of England (BoE). However, interest rates aren’t based on the bank rate alone, which is why you’ll see different interest rates from different providers.
Banks and financial institutions may use the base rate as a guideline, but they consider many other factors when deciding interest rates for products, like loans.
Interest is usually expressed as a percentage of the total amount you’re borrowing. You can calculate how much it is in pounds using a loan calculator. Loan calculators work out how much interest you’ll pay by taking these factors into account:
- the amount you’re borrowing
- your loan term (how long your loan is for)
- the interest rate
Bear in mind, a loan calculator can give you an estimate of how much interest you will pay but you should request a quote from the lender to find out the actual amount you’ll be charged.
Is Annual Percentage Rate the same as interest rate?
Annual Percentage Rate (APR) is not the same as interest rates. APR relates to the total cost of borrowing over the course of the year, including any compulsory fees and charges on top of the interest.
You may sometimes see the same product advertised with a low interest rate and a higher APR – this is because the APR includes charges. So, comparing the APR on different financial products is an easy way to find out which will cost you the most money overall.
Why do I need a loan calculator to work out interest?
You don’t have to use a loan calculator to work out how much interest you’ll pay on a loan… but it makes it easier.
Doing the maths ourselves can get very complicated very quickly, as interest is calculated based on the amount you owe. This makes sense, but where it gets complicated is the amount you owe decreases every time you make a payment, so the amount of interest you’re paying changes to.
What this means is that if you have an APR of 5%, for example, it isn’t as simple as working out 5% of how much you’ve borrowed. Instead, you must work out 5% over the course of twelve months on an amount that’s decreasing every month.
So, you can see how using a free online loan calculator can save you time and effort.
5 factors that affect how much interest you pay
As we mentioned above, lenders take a variety of factors into consideration when deciding the interest rates of certain products.
1. Risk to the lender
The risk to the lender has a big influence on interest rates. The more risk there is of you not repaying the loan, the higher interest rates tend to be. Lenders will typically assess your risk based on one or more of the factors below:
- financial history – if you have a poor credit history, you’ll be perceived as riskier to the lender, as they use your past financial behaviour to predict your future behaviour
- affordability – if you have a good level of income that covers your current repayments and then some, your risk level will be reduced
- your recent credit applications – if you have made lots of recent credit applications, you may look like you’re desperate for credit, which will make you appear high risk (even if you were approved)
2. Loan type
The type of loan also affects the interest rate you’re offered. Unsecured loans, for example, have higher levels of interest, as there’s greater risk to the lender. The loan isn’t secured to anything – so the lender has no collateral to sell if you can’t repay the loan. To offset the risk to themselves, lenders tend to charge higher interest rates on unsecured loans compared to secured loans.
Secured loans use an asset such as your home as security. Your asset can be sold to cover the cost of the loan in the event of you not being able to repay it. This added layer of protection to lenders is the reason behind the lower interest rates.
3. Loan amount
The amount you’re looking to borrow will also affect the rate of interest. Lower amounts tend to have higher interest rates as they are generally repaid quicker. While higher amounts have lower interest rates because you’re paying them over a longer period.
4. Loan term
The length of the loan term will also impact the interest rate. If the term is short, then the interest is likely to be higher. If the term is longer, then the interest will be lower.
Bear in mind though, the longer your loan term, the more you will pay in interest overall, even if the interest rate is low.
5. Your credit score
Your credit score will also impact the interest rate the lender is willing to offer you. As we mentioned above, interest rates are one of the ways lenders mitigate their risk. If your credit score indicates that lending to you may be riskier than lending to someone with a higher credit score, then you’ll likely be offered a higher interest rate. So, it’s wise to get your credit score to the best place it can be before seeking out credit.
Within these categories, each lender will have their own specific criteria, which is why it’s important to make sure you’ve checked the criteria of the lender before you apply.
How can I get a better interest rate?
If you already have a loan but think you should get a better interest rate, you could try negotiating with your lender. It’s entirely at their discretion whether they decide to change your interest rate, but it won’t affect your credit score or eligibility to ask.
If you’re in financial difficulty, don’t delay in contacting your lender and explaining the situation, as they may be able to lower or freeze your interest for a period if you’re struggling. However, this is by no means guaranteed. So, it’s important that you ensure you can make your monthly repayments before you sign a loan agreement, to avoid financial difficulty further down the line.
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