An interest rate is the amount you’ll be charged for borrowing money. It determines how much extra you will repay on a loan or earn on savings over time. Interest rates are an important consideration when taking out a loan, but you may be unfamiliar with how they work and how they could impact your life.
In this guide, we’ll cover everything you need to know about how interest rates work, including:
- What interest rates are
- The different types of interest rates
- Why interest rates are important
- What factors determine the interest rate on a loan
- How interest rates may impact you when borrowing money
- How interest is calculated and applied in real terms
Taking out a secured loan is a big decision. If you need any further information, take a look at our Loan Basics page for more useful guides.
What are interest rates?
An interest rate is essentially the cost of borrowing money. Most people borrowing from a lender will be charged interest. If you’ve taken out a loan or credit agreement, the interest rate is the percentage of the money borrowed that you have to pay back. This is in addition to the original loan amount and any fees.
You may also earn interest through savings and investments. For example, when you have cash stored in savings accounts, the banks or institutions holding your money effectively borrow it from you. This means they have to pay you an interest rate on the amount you have saved.
Interest rates are usually expressed annually. This makes it easier to compare different financial products like loans, credit cards and savings accounts.
How do interest rates on borrowing work?
Interest rates are applied to the amount you borrow and determine how much extra you’ll repay over time.
In simple terms, interest rates work like this:
- You borrow a set amount of money
- A percentage (the interest rate) is applied by the lender
- Interest is calculated daily or monthly
- This interest is added to your balance
- You repay the loan in instalments, including both the original amount and the interest
- The balance reduces and the interest payable is also reduced
For example, if you borrowed £10,000 at a 5% annual interest rate over 1 year, you would pay around £267 in interest. This means the total amount repayable would be £10,267 (before any fees or compounding effects).
If the same £10,000 loan is taken over 10 years at 5% per year (with simple interest for illustration), the interest would be around £2,663. The total repayable would therefore be £12,663.
This shows how the length of a loan can have a major impact on the total cost. Even when the interest rate stays the same, a longer repayment term means more interest is paid overall.
What are the different types of interest rates?
There are several types of interest rates. Each one works in a different way, which makes it hard to answer the question: how do interest rates work?
When you hear or read the term ‘interest rate’, it could be referring to any of the following types:
- The Bank Rate: Also referred to as the ‘base rate’, this is set by the Bank of England in the UK. The Bank Rate is the single most important interest rate in the UK. If it rises, all other interest rates are likely to follow and vice versa.
- The interest rate charged by lenders: Banks, building societies and other lenders can set their own interest rates on mortgages, credit cards and other types of loan agreement. These are partly determined by the Bank Rate, but also by other factors, such as the level of risk being taken on by the lender. To compare interest rates on unsecured products, you need to look at the ‘APR’. Secured lending products, such as mortgages, use ‘APRC’ (more on this below).
- The interest rate offered on savings: Just as banks and building societies set the interest rates for their loans, they also set interest rates for their savings accounts. The Bank Rate is influential again, as is the type of savings account or product. Savings interest rates are usually advertised as ‘AER’ (Annual Equivalent Rate).
Simple vs compound interest
Understanding how interest is calculated may make it easier to see how interest rates work in practice:
- Simple interest is calculated only on the original amount borrowed and does not increase over time.
- Compound interest is calculated on the original amount plus any interest already added. This may increase the total amount paid or earned over time. Compound interest is more common with credit cards and savings accounts.
Fixed vs variable interest rates on loans
Interest rates on loans can be either fixed or variable. One isn’t necessarily better than the other, but both have pros and cons.
A fixed interest rate may be offered for an introductory term (such as with mortgages) or the full term of a loan (more common with personal loans). Fixed rates are unaffected by external factors such as Bank Rate changes, making it easier to budget your repayments. You won’t face higher repayments if rates increase during the fixed period, but you won’t benefit if rates come down either.
Variable interest rates could change during the term of your loan. While there is a chance you could owe more if rates increase, you could also see your repayments decrease if the interest rate falls. At Evolution Money, all our loans come with variable interest rates.
What are interest rates on loans?
Interest is charged on most types of loans, whether it’s a mortgage, secured loan, debt consolidation loan or an unsecured personal loan. The interest rate is the percentage of the money borrowed that you have to pay back on top of the original loan amount.
These rates are usually advertised by lenders as an ‘APR’ (Annual Percentage Rate) for unsecured loans or ‘APRC’ (Annual Percentage Rate of Change) for secured loans. Both figures consider the fundamental interest rate of the loan combined with any additional charges. ‘APRC’ often gives you a more comprehensive look at secured loan agreements such as mortgages, particularly if you’re on a variable interest rate.
APR gives a clearer picture of the total cost of borrowing, as it includes fees as well as interest. This makes it easier to compare different loan products.
What is the point of interest rates?
A higher Bank Rate means you’ll pay more to borrow money, but may earn more for saving it. This is often done to encourage people to spend less and save more. This, in turn, curbs rising prices and inflation. In a healthy economic climate, lower interest rates help to encourage spending by minimising the cost of borrowing.
If you already have a mortgage or another loan agreement, or you’re taking one on soon, a change in interest rates may directly impact you. You could be left paying more or less. This depends on whether the rate rises or falls and if you’ve got a fixed or variable agreement with your lender.
What factors determine the interest rate on a loan?
The interest rate offered by a lender depends on a few factors and your individual circumstances. Generally speaking, the greater the risk they’re taking on, the higher the interest rate they’ll charge. The factors most commonly considered include:
- The amount you’re borrowing
- Your chosen loan term
- The type of loan you’re taking out
- Your credit score and history
- Your deposit (for mortgages)
- The value of any assets you’re using as security (for secured loans)
How can interest rates impact your life and finances?
Interest rates could have a significant impact on your day-to-day finances. Before getting a loan, it’s important to make sure you can afford the monthly repayments. This is especially important for loans with variable interest rates. You’ll need to consider that the interest rate could increase, which would in turn raise your monthly repayments.
When interest rates rise, borrowing becomes more expensive. This could increase the cost of loans, mortgages and credit repayments. A rise may put pressure on monthly budgets and reduce how much disposable income you have available.
On the other hand, higher interest rates may benefit savers. This is because they might receive better returns on savings accounts and investments. However, if you have existing variable rate debt, such as certain loans or credit cards, rising rates could quickly increase what you owe.
Lower interest rates generally have the opposite effect. Borrowing becomes more affordable, which may make loans and credit more manageable. However, returns on savings tend to decrease, meaning your money might not grow as quickly when held in cash accounts.
How can I get lower interest rates on a loan?
Lenders ultimately have the final say on the interest rates they offer, but there are things you can do to try and secure a lower rate.
The main one is to improve your credit score. This can be done by ensuring all your financial information is accurate, making payments on time and showing you’re trustworthy with credit. Paying off other debts may also help to make you less risky as a borrower.
It’s always worth adjusting the amount you’re looking to borrow and the loan term. This will allow you to see how it influences the interest rate you’re offered.
Consider a secured loan from Evolution Money
Whether you’re looking to make some home improvements, consolidate your debts or get a loan for another reason, consider borrowing from Evolution Money. We offer secured loans for homeowners up to £105,000, with flexible loan terms from 3 to 20 years.
Check your eligibility with our online form today.
Check out our customer reviews to see why we’re rated ‘Exceptional’ on Feefo.
All loans are subject to status and eligibility. Available to UK homeowners aged 21 to 70. Terms and conditions apply. Not all applicants will be accepted.
Don’t rush into securing a loan against your home. Falling behind on mortgage or secured loan repayments may put your home at risk of repossession.
If you are thinking about bringing debts together, remember that doing so may increase how much you’ll repay and how long it takes.
What is a good secured loan interest rate?
This depends on your credit profile. Lower rates are typically offered to borrowers with stronger credit histories. Lowest rates can start around 5%, but it’s not uncommon to see rates of 13% or higher if you have a poor credit score.
Can interest rates change during a loan?
Yes, interest rates can change during a loan. But how and when they change depends entirely on whether your rate is variable or fixed. Most unsecured loans have fixed rates for the life of the term, but secured loans could be variable or fixed for a specific period.
With a variable rate, your interest rate rises and falls over the life of the loan. If the Bank of England base rate goes up or down, your interest rate and monthly payments will change accordingly. If rates rise, your monthly repayments will increase. If rates fall, you will pay less.
With a fixed rate, your interest rate is “locked in” for a specified introductory period. In those cases, your interest rate never changes during that agreed period. Because the interest rate stays the same, your actual monthly payment usually remains identical for the whole fixed term. However, over time, a larger portion of your monthly payment goes toward paying down the principal balance, while the interest portion naturally reduces. When the term ends, you’ll usually revert to a variable rate.
Why do interest rates go up and down?
Interest rates go up and down as a way of controlling inflation. When inflation rises, the Bank Rate increases to make borrowing more expensive and saving more attractive. When the economy slows down, the Bank Rate typically goes down to encourage spending and investment.
Representative 17.46% APRC (Variable)
For a typical loan of £23,120 over 120 months with a variable interest rate of 17.46% per annum, your monthly repayments would be £442.07. This includes a Product Fee of £2,312.00 (10% of the loan amount) and a Lending Fee* of £763.00, bringing the total repayable amount to £53,047.80. Annual Interest Rates range between 8.6% to 27.87% (variable). Maximum 50.00% APRC. *Lending Fee varies by country: England & Wales £763, Scotland £1,051, Northern Ireland: £1,736.
Think carefully before securing debts against your home. Your home may be repossessed if you do not keep up repayments on your mortgage or any other loan secured against it. If you are thinking of consolidating existing borrowing, you should be aware that you may be extending the terms of the debt and increasing the total amount you repay.
