When you take out a personal loan, your loan provider can calculate the interest up-front. You’ll decide how much to borrow and how long you will take to pay it back. Since the amount you’ve borrowed won’t change throughout the loan term, it’s easy for lenders to calculate how much your total loan will cost.
How Are Personal Loan Interest Rates Calculated?
Personal loan interest rates are calculated annually, known as an APR. The interest is worked out on the remaining balance you have to pay, so if you can pay it off sooner, you’ll incur less interest.
When you borrow money in the form of a personal loan, interest is calculated annually. This APR tells you how much you’d pay to borrow the money for a year.
Before you finalise your loan agreement, you will usually be sent a payment schedule that tells you what you’ll pay and when. It’s likely that your loan agreement will also tell you the total amount you’ll repay.
Read on to find out more about how personal loan interest rates are calculated.
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- – Understanding Store Card Debt.
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Personal Loan: What Is APR?
APR is the Annual Percentage Rate of your loan. It’s how much you’re paying to borrow the money for a year.
When you borrow money, the lender can calculate how much you’ll owe each year, as well as knowing exactly when you’ll be paying the money back. They can look at your whole loan term, decide what interest they’re charging and spread this across each year of your loan agreement.
A typical personal loan may come with an APR of 3.5%, This means that if you borrow £8,000 you’ll pay £280 per year in interest. Over a five-year loan term, that would mean that you’ll pay back £9,400.
When they calculate the APR, lenders will typically factor in all of your interest, fees and charges. This makes APR a realistic figure for calculating how much you’ll owe.
Personal Loan: Different Interest Rates
Lenders may charge different interest rates for different customers. Mostly, this will depend on the level of risk they’re taking on.
If you’re a low-risk creditor, likely to make repayments on time in full every month, the lender will typically offer their lowest interest rates. You may be offered a higher interest rate if you’re considered to be a risky customer, perhaps because of a bad credit score that indicates you’re not great with money.
A higher interest rate means that you’ll be paying more to borrow the same amount of money. Overall, your loan will be more expensive.
Lenders can choose to raise their interest rates to balance the risk they’re taking on. Of course, if you’re too much of a risk, they may completely reject your application.
Bad credit personal loans usually have very high interest rates. Usually, the APR on bad credit loans can be anything from 40-100%.
Here’s an example of how the interest rates can impact the amount of money you need to repay.
|Loan Amount||Duration||Interest Rate||Monthly Repayment||Total repaid||Total Interest|
This clearly shows how much more expensive a high-interest rate loan can be. Not only are your monthly repayments higher, but your interest is calculated based on the outstanding balance for the year, and so the higher percentage is ensuring you’re always paying a lot more.
With a 40% loan, you aren’t simply paying 40% of £5,000 (which would be £2,000), but you’re paying more as it’s calculated against the money left to pay off for each of the three years of the loan.
Personal Loan: Reducing the Interest on Your Loan
If you have time to spare, improving your credit rating can help you to get loans with lower interest rates. Proving that you can manage your money will open up more options for borrowing.
You can improve your credit score by keeping up with your payments, bills and existing debts. Always pay more than the minimum payment for any credit card that you’re using, and make sure that you don’t fall behind on things like your phone bill and council tax. It takes just months to start to improve your credit score.
Another way to reduce the interest you’ll pay is to make overpayments on your loan, or clear it sooner than planned. Usually, lenders will recalculate the interest if you repay ahead of schedule. Making overpayments can help you save money over the course of your loan.
Watch out for any extra costs that making overpayments might bring. Whilst many lenders accept overpayments without penalty, there are some that will add extra fees and charges if you want to clear your debt more quickly. Lenders will charge additional fees because they’re losing out on interest.
The fees can help them to take some extra money so they’re not losing out on too much profit. Before you take out any loan, it’s good to check the overpayment terms. Will you have to pay extra fees if you want to make loan overpayments?
Personal Loan: Understanding Representative APR
When you start to look into personal loan APR, you’ll see that lenders will typically list these as a ‘representative’ rate. A representative APR is used for a majority of marketing.
An APR is representative if it’s the rate that will be given to at least 51% of successful applicants. Remember that lenders can adjust the APR to suit different types of customer. When you see a representative APR, this isn’t necessarily the price that the lender will offer.
Personal Loan: Reducing Your Personal Loan Interest
To get a cheaper loan, with lower interest rates, you should clear your debt as soon as possible. When you’re applying for a loan, only borrow what you absolutely need to. Don’t be tempted to borrow a bit more.
Choose the shortest possible loan term. This will increase your monthly payments and allow you to clear your debt sooner. But, be realistic about what you can afford. It’s pointless increasing your monthly payments if you’ll struggle to afford them, and missing payments could damage your credit score and make future loans much more expensive.
Take a measured approach to designing a loan to meet your needs. Most lenders will have a loan calculator that lets you play around with the figures, moving sliders up and down to find the loan deal that suits you best.
Whilst you’ll pay higher interest to spread your borrowing over a longer loan term, this may be more sensible than leaving yourself at the limits of your household budget. Remember that you can always choose to make overpayments, but once you’ve selected a shorter loan term there’s no way to reduce your monthly cost.
How Personal Loan Interest Rates Work
Personal loan interest rates aren’t the same for every customer. Your next-door neighbour could apply for the same loan, with exactly the same bank, and get it at a much lower price. Or, you could be the lucky ones with the better APR. APR is calculated according to risk levels as well as your loan amount and term.
The loan’s APR is how much you’ll be paying to borrow the money for a year. A longer loan term will cost you more overall, whilst choosing a short loan term or making overpayments could help you to keep more of your money.
When you’re choosing a loan, be realistic about how much you can afford to pay each month. A short-term loan may be cheaper overall, but your monthly payments are going to be higher. Your personal loan interest rate is just one factor to consider when you’re choosing which product to apply for.
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