How interest works and what to watch out for

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.  

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.

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.

‍