Debt: How borrowing works

When borrowing, a crucial concept to consider is the APR, which stands for annual percentage rate. This is the cost of borrowing money over a year. It’s expressed as a percentage, which includes both the interest and other compulsory fees for a loan or credit card. It’s a crucial figure for comparing different credit products, as a higher APR means borrowing is more expensive, and a lower APR means it’s cheaper. The rate advertised, known as the representative APR, is the rate offered to at least 51% to successful applicants, not necessarily to everyone.

The APR includes the interest (this is the primary cost of borrowing) and any standard or compulsory fees, including account set up. The APR does not include additional charges or fines you might incur, like late payment fees, cash transaction fees or balance transfer fees. Penalties for going over your credit limit or making late payments are not included. APR is a useful comparison tool because it provides a more complete picture of the cost of credit than an interest rate alone. Lenders are required to tell you the APR before you sign a credit agreement, ensuring you have a clear understanding of the overall borrowing costs.

Probably the most common is an overdraft, which is when you spend more money than you have deposited from a bank account. There are two main types: An arranged overdraft is one that you’ve agreed with the bank before using. Often the bank offers you this, but sometimes you’ll have to ask them first. It’s the cheapest type of overdraft. An unarranged overdraft is when you spend more than you have without asking first. The bank covers it, but they’ll probably charge you more for the trouble, so this type is more expensive than the arranged overdraft. Overdrafts can be useful if you need a quick back up, but if you lean on them too much, the bank keeps charging you while you’re using it and it almost certainly won’t be the cheapest way to borrow.

Credit cards are another common form of borrowing. These can be with your bank or with another provider. You get a card that looks like a normal bank card and a credit limit, which the provider offers you based on a range of factors, including your income and your credit rating. A credit limit is the maximum amount you can owe on the card, which is the total of what you’ve spent, plus any interest or charges the provider adds. Credit card interest has no legal cap but common rates can range from 0% right up to 25% APR. Comparison websites can help you find the best deal. 

With credit cards you’re offered three main ways to repay. Firstly, you can pay off the whole balance in one go (clearing everything you owe). This is the cheapest option, often free if you pay in the same month you borrow. Secondly, you can pay the minimum amount which is set by your provider. This is often where problems can arise, as the minimum amount often isn’t enough to stop big credit card debts from growing rather than shrinking. The provider adds interest every month, and sometimes the minimum doesn’t cover this, so you end up owing more with each month that passes. This is when the concept of compound interest works against you. You can learn about compounding in more detail in another one of our videos. The third is paying an amount you set that covers the minimum with some more on top. This is the best option when you’re trying to clear a balance. You add whatever you’re able to spare to the minimum payment and you pay this.

Using a credit card occasionally isn’t a cause to worry, but if you’re finding that you are struggling to pay the minimum, you should call the provider early to discuss your options. 

Personal loans are a financial product that is separate to your bank account or credit card. You ask a lender to borrow a certain amount, they go away and do some checks on you before confirming this amount, or sometimes offering you a different sum. There’s always a cost involved in personal loans reflected in the APR. When you take one out, you agree to pay it back in regular instalments, usually by paying a set agreed amount each month. It is worth doing a lot of research before taking out a loan like this and note that in some cases, particularly if you need up to £3,000, a credit card may be cheaper.

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