compound interest rate

How to Understand the Different Types of Interest

Posted on 9th February 2017

Understanding how interest rate works is important if you are trying to get better at managing your personal finances. Annual Percentage Rate (APR) is essentially the interest given as a percentage spread across one year that you will repay on any credit product such as a payday loan, personal loan or an instant cash loan. APR is used interchangeably with interest in many financial circles for consumers. Interest plays an important role in the lives of every person due to the fact that it is levied on a wide range of financial products such as loans. Interest is the money that you need to pay on top of your loan. For example, if you borrow £1,000 and you pay back 10% in interest, this means that your repayment will be £1,100 in total.

Fixed interest

Fixed interest means that the loan you have taken out has an interest rate that does not change. Fixed interest is popular among borrowers for mortgages. A mortgage should always be done with fixed interest because one of the reasons for the financial crisis was people took out loans that had variable interest rates. If you have a set amount that you need to repay on your mortgage that does not fluctuate, it is easier for you to budget on what you are going to spend on. Fixed interest rates are good because they help you budget but if interest rates go down or things change in the economy, you will not be able to change your fixed interest rate loan or mortgage because you have already agreed on your loan.

Variable interest

Variable interest is put on loans and credit products that fluctuate with interest being high one month and being low another month, for example. Variable interest is affected by foreign currency fluctuations and what is happening internationally for example. If you are trying to create a stable financial life for yourself without looking at things too much, you should not take out a variable interest loans. They can be volatile because they can change frequently. This is particularly true if you have many dependents who are relying on your for their financial wellbeing.

Compound interest

Compound interest is interest that is on top of the principal amount of money and the interest on top of that. This is a term that is normally used in money management and savings. A good example of how compound interest would work in the real world is something like this. Imagine you have saved £1,000 and you have deposited the money into an interest bearing account and the account pays you 5% a year in interest. At the end of the 12 month period, you would accrue £1,050 (with the £50 being pure interest from the bank). After 1 year, you could have the option to deposit the money or you can simply allow the money to sit in the interest bearing account again at the same 5% interest rate. After another year, you would have earned a total of £1,102.50 because the interest has been compounded on top of the original interest rate and your principal savings amount of £1,000.

This is one reason why accountants love interest bearing accounts so much because they allow customers the chance to create a savings cushion for themselves.

How can you calculate interest?

The growth of online payday lenders and consumer lenders in general has created innovation in the field of figuring out what your interest rates and payments will be. Before you had to work it out yourself, now you can use repayment calculators. These will tell you how much you will be repaying in interest and they can instantly tell you the rate as well.

It is easier to use repayment calculators instead of working it out manually because you can make a mistake by using repayment calculators.

How can you search for affordable rates of interest?

Loan comparison websites can help you find the right loans for you but you can also search by interest rate as well if you are searching for an interest rate that suits your budget. The general rule to remember is that the lower the loan you are borrowing, the higher the interest rate, and if your credit rating is weak, you could be subject to higher rates of interest as well.

Tips to follow when borrowing money when it comes to interest

  • Interest is the first thing that you need to know before you take out a loan. Even before you decide on the loan amount that you want to borrow, you should know the interest rate before you go ahead. Higher interest rates tend to be used for short term consumer credit because of the higher risk of default.
  • Check if you will be subject to high late payment fees if you are late on paying your loan. Late repayment fees are to be avoided because they only add onto the interest of your loan and they can make it even harder for you to repay your loan.
  • Only choose one type of interest loan to have at any given time. For example, if you have a fixed interest loan, stick with that instead of having that and a variable interest loan. It can be difficult to manage both of these loans at the same time because on one hand, you will have steady payments to make yet on the other hand, you will feel like you don’t know how much you can repay from a month to month basis.

Interest is always going to play a role in personal finance and in consumer credit. Don’t look at it as something that you cannot understand, approach it as something that you need for your savings (compound interest) and something that you need to manage for when it comes to your loans and credit (fixed and variable interest). If you can instantly recall the interest rate for all of your consumer loans, this means if you are in good shape. If you cannot remember off the top of your head the interest rate for any of your consumer loans, this means you need to spend a few hours going through your financial statements to make sure you understand how interest will affect your finances.

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