When you borrow money, there is a cost. This is called interest. On the flip side, when you save money, the bank actually pays you interest. So interest can either cost you money or earn you money, depending on whether you borrow or save.
Let’s look at interest in simple terms. Simple interest. Simple interest is based only on the amount you borrowed. This amount is called the principal, and it’s just the original loan amount.
Say you borrowed £2000, at a yearly interest rate of 5% for three years, using simple interest. That means you only pay the interest on the original amount you borrowed.
So if no repayments were made, 5% of £2000 is £100 a year. Over three years, that’s £300 in interest. Add that to your £2000 loan and you’ll repay £2300 in total.
However, borrowing typically doesn’t work like this.
When you borrow, compound interest is applied. With compound interest, the interest grows on top of both the principal and the interest already added.
Let’s look at the same loan with compound interest. You still borrow £2000 at 5% for three years. But here’s the difference. Each year, interest is added to your balance and then the next year’s interest is calculated on this new, larger amount.
So after three years, you’ll owe £2315.25 instead of £2300. That’s only £15.25 more, but it shows how compound interest grows your debt faster than simple interest.
If you miss repayments or no repayments were made, you would also incur fees and charges, which could damage your credit score and affect your ability to borrow in the future.
There’s a little more to understand about how interest works. When borrowing, an important concept to understand is the APR, which stands for Annual Percentage Rate.
This is the cost of borrowing money over a year, expressed as a percentage, which includes both the interest and other compulsory fees for a loan or credit card. It’s an important figure for comparing different credit products, as 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% of successful applicants, but not necessarily to everyone. The APR does not include additional charges or fines you might incur, like late payment fees, cash transaction fees or balance transfer fees.
There are also penalties for going over your credit limit. APR is a useful comparison tool because it provides a fuller 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.
Interest can either cost you money when you borrow or help your money grow when you save. Because of compound interest, even small differences in rates can make a big difference over time, which is why checking the APR really matters.
Taking time to understand this now can help you make smarter choices about borrowing in the future.
If you’re thinking about borrowing, it’s important to understand your options and how repayments work. Watch our videos on borrowing options and managing repayments to learn more and understand how to stay on top of things.