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Personal Loans
Personal Loans
Personal Loans
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How interest works and what to watch out for

How interest works and what to watch out for

Rebecca Goodman
Understand how interest on personal loans works, how it affects what you repay and what to watch out for to avoid paying more than necessary.
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If you’ve ever taken credit out before, be it a loan, car finance, or a credit card, you’ll have seen an interest rate applied to your repayments.

It’s the amount a lender charges you for borrowing money and you will pay the interest back in monthly repayments.

The amount of interest you are charged is important as it will impact the overall amount of money you end up paying back to a lender.

How long you pay interest for is also important, as the longer you’re making interest payments, the more you’ll pay overall usually.

Here we look at exactly how interest works when it comes to personal loans and why it matters.

What is interest?

Interest rates are set out as a percentage and they tell you how much you will pay a lender when you borrow money. They are a very important element of a loan and the rate of interest you’re given will depend on lots of factors, including your credit score.

The amount of interest you pay will be unique to you but as a very basic example:

  • If you had a loan of £1,000 and an interest rate of 5%, you would pay back £1,050 in total.
  • If you had a loan of £1,000 and an interest rate of 20%, you would pay back £1,200 in total.
  • If you had a loan of £1,000 and an interest rate of 30%, you would pay back £1,300 in total.

What is the Bank of England base rate?

When talking about interest rates you’ll often hear the Bank of England base rate mentioned. This is a central rate set by the Bank of England and a group of experts - known as the Monetary Policy Committee (MPC) meet up to decide what this rate should be. It’s the MPC’s job to decide what the base rate should be and to keep inflation at a manageable level.

The base rate is important as it sets out the amount of interest UK banks pay. They in turn use this rate to decide how much they charge to customers when they take out credit.

If the Bank of England base rate rises, this means borrowing gets more expensive but interest paid out on savings rises too. Generally, it’s a bad sign for borrowers and a good sign for savers.

Yet if the base rate falls, this makes borrowing cheaper but savers get paid less in interest.  

Family having breakfast at home

How do interest rates work on loans?

Most personal loans have a fixed rate of interest, which means the interest you pay stays the same until you have cleared the loan. But you may come across variable interest too.

Fixed interest

If you have a loan with a fixed interest rate, this means the amount of interest you pay will stay the same. If you take out £1,000 over a five-year loan term, for example, with a rate of 10% interest. For the full five years the rate of interest will remain at 10%. 

Fixed-rate products can be more expensive as you’re paying for the privilege of the rate remaining the same. They can however offer a little more security as you know your loan repayments won’t change.

Variable interest

If you have a loan, or any other financial product, with a variable rate of interest, this means the amount of interest you pay may change. It could go up, or down, and this means you could end up paying a different amount back overall. 

In general, it’s usually cheaper to take out a variable-rate product because you are also taking on the risk that the interest rate may go up. Most variable-rate products are linked to something else, such as the base rate, so will go up or down if it does.

What is an APR?

The APR stands for the annual percentage rate. It tells you how much a loan will cost you over a year. The higher the APR, the more money you’ll end up paying back and the lower it is, the cheaper the borrowing will be. 

The APR includes the interest rate you will pay and the cost of any extra fees that may be applied, such as an application fee if there is one. It doesn’t include non-standard fees, such as fees for late or missed payments.

What is a representative APR?

When you apply for a new loan, or any other borrowing, you’ll be shown the representative APR. This is also known as the average APR and it applies to at least 51% of people who apply for the loan. However, it’s important to remember this isn’t the rate given to everyone and your APR will depend on things like your credit history and your income.

What is AER?

The AER is the annual equivalent rate and it’s used in savings products. It shows the amount of interest someone should earn over a year when they open a new savings product.

What is compound interest?

Compound interest is slightly more complicated than standard interest. It’s all to do with savings accounts and it means that you will earn interest on the money you first put away and you’ll also earn interest on any interest you earn. 

With compound interest, you will earn more, the more you are able to save. To explain it simply, the following table shows how compound interest works on a savings account with £1,000 in it which earns 5% interest.

Years Saving Initial balance Interest earned Closing balance
1 £1,000 £50 £1,050
2 £1,050 £52 £1,102
3 £1,102 £55 £1,157

How do lenders decide how much interest to charge?

Lenders who offer loans and other credit products, need to decide how much interest to charge when a person takes out credit. They tend to look at the following when calculating the interest rate:

  1. The borrower’s credit score: when you apply for a loan, the lender will check your credit score. It does this to see how much risk it is taking on by lending money to you. If you have a good credit score, you will usually have a cheaper interest rate. But if you have a poor credit score, you can expect to pay more in interest.
  2. The lender’s own rules: every lender will have its own set of rules when it comes to borrowers. It may only lend to people who earn a certain amount of money, for example, or those with an excellent credit score. It will use this criteria when assessing your application for credit.
  3. Market conditions: all lenders make their decisions around interest rates with the bigger picture in mind. They will keep a close eye on the Bank of England’s base rate and the wider economy when working out interest rates.

How long do interest rates last for?

Interest rates don’t always stay the same. If you have a fixed-rate product, the amount of interest charged usually remains set until you have paid off a loan and if you have a variable rate of interest the rate may change.

There are also promotional interest rates to consider. These are set interest rates which only last for a certain amount of time. For example, you might take out a credit product - such as a loan or a credit card - which has a 0% rate of interest for 12 months. After this time, the rate will change and you will start paying it.

If there is a promotional rate on a loan you’re taking out, or any other financial product, you should be told what the rate is, how long it lasts for, and what rate will apply after this time.


FAQs

What is an average interest rate for a loan?

Interest rates are set by looking at a range of different things, from the borrower’s credit score to the Bank of England base rate. If you have a good or excellent credit score, you can expect a cheaper interest rate when compared to someone with a poor credit score. 

What are the cheapest types of loan?

The cheapest interest rates are usually given to people with excellent credit scores. This is because a lender is taking on very little risk when lending money to them. A secured loan, where the loan is secured against an asset you have such as your home, is also usually cheaper than taking out an unsecured loan.

What is the interest rate in the UK today?

The Bank of England base rate is currently 4.5%, following the latest decision in March to hold rates. It is expected they will fall towards the end of 2025, which will make borrowing cheaper for consumers.  

Why are interest rates so high?

Back in 2020 when the coronavirus struck, interest rates fell to historic lows but then began to creep upwards. During the cost-of-living crisis, they were raised by the Bank of England to try and combat high inflation.

Personal Loans
Personal Loans
Personal Loans
Min Read
How to find the best personal loan

How to find the best personal loan

Rebecca Goodman
Taking out a personal loan can be a financial lifeline, and you can use the money to pay for just about anything - from a new car, a wedding or even home improvements.
Read More

Taking out a personal loan can be a financial lifeline, and you can use the money to pay for just about anything - from a new car, a wedding or even home improvements.

You choose how much you want to borrow and, if approved, you can have the money usually on the same day in your bank account.

Loans can be used to pay for big ticket items, like a holiday, or they can be used for short-term, emergency funding if you don’t have the cash, such as a broken fridge or a failed MOT.

But with so many loans to choose from, how do you find the best one for your needs? Here we look at everything you need to know on comparing and finding the best personal loan.

Person searching for a personal loan on a mobile device

What do look for in a personal loan

You can take out a personal loan from lots of different places; banks, building societies and specialist lenders. Most providers allow you to take out loans online, or through an app, but you can also apply in person in a bank branch.

Here are a few key things to look out for when you’re looking for a loan:

  • Monthly payment: every month you will make a repayment to your loan provider, over the term of your loan. This payment will include any interest applied to the loan and you must make these payments. If you miss a loan payment, this can negatively impact your credit score and you may be charged a fee.
  • Interest: when you take out a personal loan you will be charged interest on the money you borrow. Before you agree to take out the loan, you will be told the interest rate and exactly how much extra you’ll be required to pay on top of your loan. If the interest rate is 10%, for example, and you’ve taken out £1,000, you will end up paying back £1,100.
  • Loan term: you choose the loan term when you take out a personal loan but you can often take one out over anything from a few weeks to up to five years on average. While it may be tempting to choose a longer term, this also means you will be paying interest for a longer period, and it may cost you more overall.  

How can I use a personal loan?

You can use a personal loan for just about anything and as the money is transferred to your bank account, there are no limits on where you spend the money. However, when you apply for a personal loan you will usually be asked the reason you’re applying for the loan. Some of the most common reasons include:

  • Debt consolidation: if you are paying off several different debts, with high interest rates, you may be able to use a personal loan to clear these debts. While you are still taking on more debt, using the loan to clear the other debts means you will then just have one payment rather than several. If the interest rate is lower on the loan you will also be saving money overall, as you’re paying out less in interest.
  • Wedding: the average cost of a wedding can be around £20,000 and if you don’t have this money saved up, a personal loan could be used.
  • Holiday: depending on when you go away, a holiday could cost thousands of pounds and instead of using a credit card to pay for it, you could use a personal loan if you don’t have the money saved up.
  • Bridging loan: if you’re selling a property and buying a new one, a bridging loan can be used to fill the gap in between. It can also be used for other property-related funding such as if you’re buying a house at auction or starting a house renovation project.
  • Buying a new car: one of the most popular reasons for taking out a personal loan is to buy a new car. This is because using a loan to buy a car means you own the car outright, instead of paying for it with car finance or leasing it. The interest rates are often cheaper with a personal loan than with a car finance agreement too.
  • Home improvement: a garage extension, loft conversion or even a garden redesign can cost a lot of money which often needs to be paid out in one go. A personal loan is one way to pay for this, and can often be cheaper than other forms of credit such as credit cards.
  • Unexpected expenses: no matter how much we plan, unpredictable things can happen such as household appliances or cars breaking down. If you don’t have the cash to pay for these, a personal loan could be used.

What are the main types of personal loan?

There are several different personal loans to choose from, and the right one for you will depend on your reason for taking out a loan, how much the loan is, and things like your credit score.

The two main types are unsecured and secured loans:

Unsecured loans

These are the most common types of personal loan where the amount of money you can borrow depends on your income and your credit score.

Secured loans

To take out a secured loan you need to have something - such as a property - to use as collateral. You can often take out more money with a secured loan but there’s also a higher risk attached to these. If for any reason you can’t repay the loan, the asset you’ve used as collateral could be taken off you. In the worst-case scenario this could mean your home being repossessed.

There are also guarantor loans which require another person, usually a family member or close friend, to add their name to the loan agreement. The guarantor then agrees that they will make the loan repayments if you’re unable to.

How much can you borrow?

You can usually borrow anything from a few hundred pounds up to £15,000 or £20,000. The amount you can borrow depends on your…

  • Credit score
  • Income
  • Outgoings
  • The number of dependents you have
  • If anyone else contributes to your income

Am I eligible for a loan?

To get the best personal loan rate, with the cheapest interest, you will need to have a good credit score. These loans are reserved for those with good, or excellent, credit scores, and these people will also usually be able to borrow higher amounts.

If you don’t have a good credit score, you may still be able to take out a personal loan but the interest rate you will be charged will be higher. You may also be limited to a smaller loan amount.

Will applying for a loan affect my credit score?

When you apply for a loan, you’ll be told the amount you can borrow and also the interest rate. But as you are applying for credit this will also be marked on your credit score, even if you’re not accepted for the loan. This is the case no matter what type of credit you apply for - from a loan to a mortgage.

But there is one way to find out if you might be accepted for a loan without it making a dent on your credit score. You can use a free eligibility checker which will show you how likely it is that you will be accepted for a loan but without making a mark on your credit score.

How to boost your chances of being approved for a loan

If you don’t have a perfect credit score, there are lots of things you can do. None of these are overnight fixes but if you implement them all, your credit score will improve over time. They include:

  • Join the electoral roll: signing up to the free electoral roll means you can vote but it also helps your credit score as it is used to verify your identity. It’s free to do this on the Gov.uk website
  • Always make repayments on time: if you are late with a credit repayment, or you miss it altogether, this will leave a negative mark on your credit score. If you think you’ll forget set up a direct debit so you never miss a payment.
  • Watch your credit ratio: you’ll have a better credit score if you’re not always using all of the credit available to you. If you have a credit card with a limit of £1,000, for example, you don’t want to always have a balance of close to the £1,000 mark.
  • Check your credit score: make a note to regularly check your credit score (it’s free) with one of the leading credit reference agencies. This allows you to spot for any inaccuracies such as a wrong address or name.  

Where to find a loan

There are lots of lenders and loans to choose from, all with different rates and requirements. That’s why it’s crucial to compare different loans and not to just go with the first one you find.

Always take the time to shop around and compare loans before you apply to make sure you’re getting the best one for you.

It’s quick and easy to do this with a comparison website and always take the time to read the small print before you sign on the dotted line.

FAQs:

What is an APR?

The APR is the annual percentage rate and it’s used by lenders to calculate how much you will pay when you take out a loan. You must be told the APR before you take out a loan.

How do lenders decide who gets a loan?

Lenders look at a range of different factors when deciding who gets a loan, the amount they can take out, and what interest rate is charged. These include the person’s credit score along with factors like their income and credit score.

What happens if I’m rejected for a loan?

If you’re rejected for a loan don’t panic. There are lots of reasons why this can happen and sometimes it’s not obvious. First, look at your credit record and see if there’s anything strange there - and what your overall rate is. Then have a look at the eligibility for the loan to check you have met the requirements. You can also ask the lender for a reason, although they’re not obligated to give one. Whatever happens, don’t panic and apply for lots of other loans. This can negatively impact your credit score as it can look like you’re not managing your finances well.

Can I get a loan with a bad credit score?

Yes you can get a personal loan if you have a bad credit score but you will usually be charged a higher interest rate and will be able to borrow a smaller amount than a person with a better score.

Are there early repayment fees?

There may be early repayment fees to pay if you pay back your loan early. That’s because the lender is making less money overall from your loan in interest payments. If there are fees to pay these will be listed in the terms and conditions of the loan.

What happens if I can’t repay a loan?

If you’re struggling to repay a loan the first thing to do is speak to your lender. They need to listen to you and help you to find an affordable repayment plan. If you’re not getting anywhere or you need more help, there are a number of free and independent debt charities which can help including Step Change and Citizens Advice.

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