Know Your Loan: Interest Rates and What They Mean for You
No matter what kind of credit is extended to you, whether you have a mortgage, a credit card, or even a logbook loan, you’ll have to repay that credit plus interest. Interest is a sum of money that you will pay regularly in exchange for the use of money that is lent to you. Understanding how interest works and how it is applied to various loan types can help you make the right financial decisions.
It’s the Price You Pay
When any kind of lender extends credit to you, whether that credit is in the form of a loan or a credit card, that lender assumes some risk. What if you default on your payments or fail to repay at all? How will the lender be able to continue to offer its services? Interest is the solution in this case. Any time you borrow money, you’ll be charged interest, which may be applied as a flat fee or as a percentage of your outstanding loan amount. There are many different types of interest, too, so it helps to familiarize yourself with them.
Principal Balance vs. Interest
Assume for a moment that you take out a loan for £10,000 and you’ll need to repay that loan in three years. Your interest rate is 5%, which means you’ll pay 5% of the total loan value as interest. The lender will first determine the monthly payments you’ll need to make over the course of those three years.
Without interest, your monthly payments over 36 months would be £277.78. At this point, your lender has a choice. They could charge your 5% as an annual percentage rate, which means you’ll pay 5% of the outstanding loan amount each year. Here’s how that would look:
- Year 1 - Your principal loan balance is £10,000, so you’ll be charged £500 in interest (5%) for this year.
- Year 2 - At the start of the second year, you would have already paid roughly £3,333.36 of the principal loan balance, leaving you with £6,666.64 outstanding. The 5% interest on this amount would be equal to £333.33.
- Year 3 - At the start of the third and final year, you would have paid a total of £6666.64, leaving a principal balance of £3,333.36. Your 5% interest for the final year would total £166.67.
In this case, the principal balance left on the loan – the amount you owe before any interest is applied – can make a tremendous difference in the amount you repay over time. If you manage to pay an extra £1000 in the first year, it’ll save you money on interest for the following year.
Your lender may also charge you a flat 5% interest based on the total amount of the loan. This means that you’ll be charged a total of £500 for the duration of the loan. With this type of interest, making additional payments on the principal balance may shorten the duration of the loan, but it will not lessen the amount of money you owe.
What Lenders Will Tell You
Although interest itself can be a little complicated, the truth is that UK law requires lenders to tell you in advance how much interest you will pay over the course of your loan if you make every single payment on time as scheduled. In fact, lenders should break down the payment schedule to show you how much of your payment applies to the principal balance and how much applies to interest for every single payment you make. Make sure you take the time to carefully review this information and understand it before you sign a contract.
Should You Make Extra Payments?
Most financial experts will tell you to pay more than the minimum payment required on any credit that is extended to you. This is especially true of credit cards since interest rates can be significantly higher than with loans. Whether you’re paying off a mortgage, a car loan, a credit card or for example logbook loans in Manchester there are always benefits associated with making extra payments or paying more than the minimum required. Even if you don’t manage to save money on interest charges, you can shorten the duration of your loan.
Understanding your interest rates and how interest is applied to the amount of money you borrow can help you make better lending decisions both now and in the future. Remember that paying extra payments or more than the minimum can save you a significant amount of money or, at the very least, reduce the overall length of your loan.