How borrowing works

When you borrow money there is a cost. That 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.

Typically we may think about 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 £2,000 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 £2,000 is £100 a year. Over three years, that’s £300 in interest. Add that to your £2,000 loan and you’ll repay £2,300 in total.

If no repayments were made, you would incur fees, charges and you could damage your credit score. In reality, 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 £2,000 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. After three years, you’ll owe £2,315.25 instead of £2,300. That’s only £15.25 more, but it shows how compound interest grows your debt faster than simple interest.

There is a little bit more to know about how interest works. When borrowing, a crucial concept 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 a crucial 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, 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 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.