Various factors must be considered when you choose to take any form of financing. Interest rates are a highly important factor that will affect the amount of money you end up repaying after borrowing. Ideally, you would want to pay the minimum possible interest rate. To achieve this, you need to work on several issues, amongst which is understanding what can cause the interest rate you get on your borrowing to rise or fall. Let us begin by defining interest rates.
What are interest rates?
Interest rates are the fee you pay for borrowing money or the return you make on savings. It is calculated as a percentage of the total value of the amount borrowed or saved.
If you are a borrower, then the interest rate will be the amount you will pay above and beyond the amount borrowed. This is the profit the lender will make from granting you financing. It is typically applied to all forms of borrowing, be it a credit card, home mortgage, van financing, or payday loan. When making repayment on the loan, part of each instalment is a portion of the actual borrowing and the rest is the interest amount.
If you are a saver, the interest rate will also be a percentage calculated on the amount of savings made and added to your account. The more interest or savings rate that your account attracts, the more money that is added to the balance.
It is important to pay attention to interest rates as even minor fluctuations can result n big changes, more so for large and long-term borrowings. It also means you need to understand the difference between fixed and variable rates.
What are fixed and variable interest rates?
When you take a loan that has a fixed interest rate, it means that for the entirety or a set duration, the interest rate that is applied will be constant. This option is sometimes attractive to borrowers as it allows them to be assured as to what level of debt they will be obligated to pay. There is consistency that allows them to better plan their finances.
Variable interest rates are however usually pegged on the base rate and will fluctuate in the same direction. This can sometimes make planning your repayment of a loan more unpredictable as the rate will rise or fall depending on what is happening to the base rate. It can be bad news when the base rate rises as even a minor change can mean having to repay much more than you thought.
What is the base rate?
The base interest rate is the rate that the Bank of England charges banks and other lenders when they borrow money. It has a direct impact on the interest rates that lenders set for their borrowers. When a borrower has a variable-rate loan, it will be adjusted according to the fluctuations in the base rate. If the base rate rises by 0.5%, then so too will the interest on the loan taken by a borrower.
The impact is similar on savings. If the base rate rises, then so too will the savings rate. Thus, an increase in the base rate is good news for savers but bad news for borrowers.
When considering what kind of loan to take up, it is important to understand the difference between variable and fixed rate loans, thus not being surprised when you see changes to your expected repayment.
How interest rates affect my loan?
As said, interest rates will impact the amount of money you will repay when you take a loan. They are a fee that the lender charges to make a profit from lending you money. The higher the interest rate, the more money you will repay.
You can easily use an online loan calculator to find out how much you can expect to repay. To get the most accurate estimate you will need to have certain information including the interest rate, loan amount and loan duration. Once you input this data, it will generate the monthly repayment amount that will include both the interest and principal amounts. The principal amount relates to just the loan amount borrowed before the lender calculates his fees or profit.
It is important to also realise that not all borrowers are treated the same. Some are considered to be riskier to lend to than others. Data such as credit scores are used by lenders to help gauge the risk associated with lending money to an individual. The better your credit score, the lower the interest rate you can secure from a lender. This is because you will be considered a safer or low-risk person to lend money to.
Factors that can affect your credit score include:
- Credit history – the longer a history you have of having borrowed, the easier it will be to gauge what kind of a borrower you are. If you have a long history of borrowing and good repayment, your credit score will be better.
- Payment history – this examines how timely you are about full repayment of due instalments. Where you have a good history of paying your full instalments on time, the better your score.
- Debt level – Lenders will want to be assured you are not so burdened with debt that it makes it challenging to make repayment on your loans or other financings like credit cards. They will need to compare the level of your income versus your debt level to determine if you can afford another loan facility.
- Credit mix – having a good history of repayment on different kinds of credit will also help your score.
Lenders will also look at your employment status. Those in permanent jobs and with a long work history are considered a better risk. If not employed, but run a business, your financial records and accounts will need to be reviewed to ascertain how good a revenue stream you have to support loan repayment.
Credit scores, financial records, and employment status are personal factors that go into influencing what kind of interest rate you can get. The base rate is an external factor that individuals have no influence over. This means you need to first consult with your lender to find out exactly what interest rate you can get when you need financing.
Note that even lenders do not determine the interest rate they will give a borrower the same way, even when presented with the same information. They each have their own way of assessing the risk of a borrower, meaning that you may find some lenders willing to give you a better interest rate on borrowing than others. This is why borrowers need to shop around to identify lenders willing to grant them the best deal.
