How Does Interest Work?

Have you ever found yourself pondering exactly how interest on your loan is calculated and why it plays such a crucial role in your finances? If you’ve ever taken out a loan or considered doing so, grasping the concept of interest is very important.

At its core, the concept of interest revolves around the cost of borrowing money. It is the price you pay for using someone else’s funds, much like paying rent for living in someone else’s property. When you borrow money, whether for urgent needs or to cover unexpected expenses, the lender charges you an interest rate on the amount borrowed. This rate is what makes up the primary cost of your loan. It’s crucial to understand how this works because it affects how much money you will need to pay back each month and overall.

What is Interest?

Imagine you’re in need of a car for a weekend trip, but instead of buying one, you decide to rent it. Renting means you get to use the car for your trip, but once the trip is over, you return the car and pay for the time you used it. Borrowing money works in a similar way. When you take out a loan, you’re essentially renting money from a lender. 

You use the money to cover your needs—maybe it’s to fix a sudden leak in your roof, use the money as deposit towards a brand new car, or consolidate other debts. However, just like with the car, the money isn’t yours to keep forever. You agree to pay it back, and just as the car rental company charges you for using their car, the lender charges you for using their money. This charge is what we call interest.

Interest serves as the cost of borrowing money. It’s how lenders earn from the service they provide and also how they cover the risk they take in lending money. The interest rate, which is usually a percentage of the amount borrowed, determines how much extra you will need to pay back on top of the borrowed amount.

How Is Interest Calculated?

Understanding how interest is calculated on your loan is crucial because it directly affects the total amount you will owe and your repayment schedule. When considering a short-term loan, you will typically encounter two main types of interest rates: fixed and variable. These terms might sound complex, but their implications for your financial commitments are straightforward and significant.

Fixed Interest Rates: Imagine you decide to fix the rate of interest on your loan; this means the interest rate set at the time of the loan agreement remains unchanged throughout the duration of your loan. For example, if you borrow £500 with a fixed interest rate of 15% over a three-month period, the interest rate does not fluctuate. This type of rate provides a sense of security and predictability because you know exactly how much you need to repay each month, allowing for easier budget management. Your payments would be consistent every month, simplifying financial planning and giving peace of mind.

Variable Interest Rates: On the other hand, a variable interest rate can change over the duration of your loan. This rate typically ties to  a benchmark rate, such as the Bank of England’s base rate, and can fluctuate as this underlying rate changes. If you were to choose a variable rate for your £500 loan, and the rate was initially 15% but the benchmark rate increased, your interest rate might rise as well, affecting your monthly repayments by potentially increasing them. This type of rate might offer lower interest costs initially but carries the risk of increased payments, which could impact your budget if rates rise significantly.

At One Stop Money Shop, our loans come with fixed interest rates, and there’s a good reason for this. We understand the importance of stability in your financial life, especially when you are dealing with unexpected expenses or financial emergencies. With a fixed interest rate, each repayment amount is set from the beginning and does not change throughout the term of your loan. We believe that by providing loans with fixed interest rates, we help eliminate some of the uncertainties that can accompany borrowing, allowing you to focus more on what matters most—getting your finances back on track without any added stress.

Calculation Examples: To help you grasp how these interest rates translate into actual payments, let’s consider a real-life scenario with a fixed interest rate:

• Loan Amount: £500
• Interest Rate: 15% annually (fixed)
• Loan Duration: 6 months

Since the interest is annual, for a six-month period, you would be charged half of the annual rate:

• Half of 15% = 7.5%
• Interest for 6 months on £500 = 7.5% of £500 = £37.50

Thus, at the end of six months, the total amount you need to repay is:

• Principal (£500) + Interest (£37.50) = £537.50

The breakdown of each repayment, if split into monthly instalments, would be:

• Total Repayable / 6 months = £537.50 / 6 ≈ £89.58 per month

This data is used for example purposes only

The Upsides and Downsides of Paying Interest

Paying interest isn’t always the best situation, but there are some perks to using credit when managed wisely. On the flip side, there are notable drawbacks, especially when dealing with high-interest credit options.

Upsides

• Helps You Afford Big Purchases:

  In a perfect world, we’d all have the cash to buy a house, a car, or other big purchases without needing credit. However, for most of us, that’s not realistic. Borrowing money allows you to secure essential things like a house deposit, or a vehicle, which might otherwise be unattainable.

• Allows You to Make the Most of Your Money:

  If you’ve got a solid credit score and can qualify for loans with low-interest rates, you can use that to your advantage. For example, even if you have the cash to buy a car outright, it might be smarter to take out a low-interest loan and invest the money instead.

   

Downsides

• High Costs with Some Credit Options:

  If your credit score isn’t great, getting a loan with a low interest rate can be tough. Higher rates mean bigger monthly payments, which can strain your finances. Even with good credit, borrowing costs can vary greatly depending on the type of credit you’re using. Credit cards and unsecured personal loans often come with higher interest rates compared to secured loans like mortgages or car loans. Our short term loans, on the other hand, have transparent interest rates that won’t change throughout the duration of your loan.

   

• Interest Can Increase Your Debt:

  If you’re only making small payments on a loan with a high balance and high interest, your debt can actually grow instead of shrink. This can happen with certain repayment plans, like income-driven plans for student loans, where the interest adds up faster than you’re paying it off. However, our loans come with set, regular payments, so this isn’t something you need to worry about.

   

Do Short-Term Lenders Charge More to Borrowers with Bad Credit?

Short-term lenders typically charge higher interest rates and fees to borrowers with bad credit. This is because individuals with poor credit histories are considered to be potentially a higher risk by lenders. When someone has a history of missed payments, or other financial difficulties, lenders perceive a greater likelihood that this person may struggle to repay the loan. For borrowers, this means that taking out a short-term loan can become a costly endeavour if their credit score is less than ideal. The higher interest rates can increase the total amount repaid, turning what might seem like a small loan into a much larger financial cost. 

However, One Stop Money Shop stands out by taking a different approach. We are committed to working with customers regardless of their credit history. Whether someone has excellent credit or has faced financial challenges in the past, we are always ready to consider your application. We understand that everyone’s financial situation is unique and believe in providing opportunities to all types of lenders.

Moreover, we offer affordable plans that are tailored to suit the individual needs of our customers. We focus on making regular payments manageable and ensuring that the loan is structured in a way that you can afford. Our commitment to responsible lending practices means they will not offer a loan to someone who cannot afford to repay it. We take the time to assess each application carefully, ensuring that the loan product offered is suitable for the borrower’s financial situation. 

Navigating the world of loans and interest rates can be daunting, especially when unexpected expenses arise. However, we hope that understanding the basics of how interest works can help you make the right choice for you.

At One Stop Money Shop, we understand that life can throw curveballs, and financial challenges can affect anyone, regardless of their credit history. That’s why we’re committed to offering loans that not only provide the funds you need but also do so in a way that is transparent, fair, and tailored to your situation. We’re not just about lending money; we’re about helping you regain control over your finances and move forward with confidence.