Taking an interest in 'interest'
Why care about ‘interest’?
UK households are taking on more debt than before. It is important to understand the costs of borrowing, in order to make informed decisions. One of the main costs of borrowing is ‘interest’. For Debt Awareness Week this week, we're looking at the role of interest when it comes to debt.
What exactly is 'interest'?
Interest is a fee that is charged for money. Interest can apply when you borrow money (for example, if you take out a loan from a bank or get a credit card) or when you lend money to someone else.
There are two sides to interest. The person borrowing money is paying it. The person lending money is receiving it.
The amount of interest that you are charged is called an ‘interest rate’. It is shown as a percentage of the money borrowed.
Interest rates are determined by three things:
1. The amount of money that you borrow or lend,
2. The amount of time that you have agreed to borrow or lend the money for, and
3. The likelihood that the money will be repaid.
Interest usually needs to be paid monthly to the lender. The monthly interest payment is usually a smaller amount than the total value of the money borrowed.
The Risk & Return gamble
Anyone that lends money is taking a risk, as they might not be paid back. Lenders want to reduce this risk.
The old phrase ‘the higher the risk, the higher the return’ can be true when it comes to lending. Lenders try to assess the risk of not getting their money back. If they think the risk is high, they might charge more interest and the loan will be more expensive for the borrower. Some lenders might decide not to lend at all. If they think the risk is low, they might charge a lower rate of interest.
Interest allows the lender to receive a regular payment whilst the loan has not been fully repaid.
With risk also comes a potential return. The possibility of a return is that the borrower pays all of the money back and the interest. That means that if the loan was £100 and the borrower paid it all back with interest, the lender would receive more than £100 in the end.
“A pound in your hand today is worth more than in the future”
The Time Value of Money concept means that the cost to borrow money reflects the fact that money loses value over time. So if someone lends £100 to you today, that same £100 will be worth less in the future.
That's because if you have a pound today, you can invest that pound and earn interest on that money. So when a lender lends a pound, it will consider how much it could have made if it had invested that money elsewhere. Lenders charge interest to protect the value of their money.
Getting help with debts
If you get into unmanageable debt, don't suffer in silence! Speak to a trusted friend or family member and contact a debt specialist organisations for free advice, such as Step Change or Citizens Advice Debt Management.
Borrowing can be a smart way to access money, especially when interest rates are low. However it’s super important that you check whether you can afford to pay back the loan and the interest payments.
Being aware of the costs means that you can you can factor in that you will pay more than what you borrowed and ultimately, you can make better financial decisions.
This article is for information purposes only. It is not intended to be used as financial advice. You should seek specialist advice from your bank or a qualified Financial Advisor before making any financial decisions.