At first glance, interest rates seem like they should be quite simple. Interest is the rate that you’re charged to borrow money, such as a personal loan or a credit card. However, especially when it comes to the Annual Percentage Rate (APR) and compound interest, it can be a lot more complicated.
Interest rate vs. APR
The main difference between an interest rate and an APR is that, if there are any fees involved in the borrowing (for example, an annual credit card fee) then this will be factored into the APR and not into the interest rate. That’s why the interest rate quoted is often lower than the APR. If there is no arrangement fee to pay for the card or loan then there may be no difference between the interest rate and the APR.
The basics of interest
Interest is pretty straightforward to start with – if you’re paying 10% interest on a £1,000 loan then that will cost you £100 over the course of a year or £33 if you borrowed the money for just four months. Compound interest, however, can make things a little more complicated.
Savings: The way that compound interest works is – to use savings as an example – you earn interest on the money that you save for the first year. Then after the first year you’ll be earning interest on those original savings – and you’ll be earning interest on the first year’s interest. So, you can earn a lot more interest on savings that way.
Debts: Unfortunately, this also applies to debts. So you’ll pay interest on the original borrowing and you’ll then also pay interest on the debt interest applied to that original borrowing, which increases each year. The longer the period over which you have the debt, the more interest you pay. It’s easy to underestimate how much this can add to your debts – for example, if you borrowed £1,000 at 15% over 20 years without making any repayments, with compound interest applied, you’d owe £16,400. If there was no compound interest on that debt the interest would be just £4,000.
You can explore how interest rates and repayment period affects the total amount you repay by using our loan calculator – it’s capable of looking at loan values from just £500 to £25,000+ over periods as long as 10+ years. You’ll soon realise the impact of the APR% and the effect of compound interest.
The different types of APR
All lenders are required to tell you what the APR is for a loan or credit card before you borrow so it’s a useful comparison tool when you’re trying to decide which is the best credit option for you. However, there are two different types of APR and you won’t necessarily get the first one that you see when you’re looking at a loan or credit card.
The representative APR. This is the rate that is generally advertised with a financial product, such as a loan or a credit card. However, only 51% of people whose applications are accepted will actually get the representative APR or better. Most APRs are calculated using an assumed credit limit and will factor in the annual interest you’re likely to pay on every day purchases, as well as any fees or charges that apply. However, these are all estimates. So, for example the representative APR on a credit card is calculated assuming a credit limit of £1,200 – but that doesn’t mean that is the credit limit you’ll be offered. Another point to note with the representative APR is that – for credit cards, for example – this advertised rate is always the purchase rate. So, it is the rate that you’d pay if you were offered the representative APR for any purchases you make. There might be a totally different rate for balance transfers.
The personal APR. This is the rate that you will be offered for the loan or credit card you’re looking for once you’ve actually made the application. Lenders tend to reserve the representative APRs for the customers they think are the most attractive so, unless you have a great credit score, then your personal APR could be quite different. Your personal APR will be compiled from a number of key factors, including how old you are, how much you earn, how much you spend and what your credit score is. The better your credit score, the more likely you are to get a good personal APR.
APRs and 0% borrowing
0% credit cards are a very attractive opportunity. It basically means that you won’t have to pay the APR on any debt you have on the credit card until the offer period runs out. Some cards offer 0% on balance transfers and others on spending – there are also some cards that will give you 0% on both. When you’re signing up for a card like this make sure you still check the APR and that you’re happy with it. Once the 0% period expires then the APR will kick in and you’ll have to be prepared to pay it if you have outstanding debt.
Amanda Gillam is Solution Loans's General Manager and has been since 2009. She is also a prolific writer on personal finance issues, and has been quoted numerous times in articles published on 3rd party websites and in press releases. Her...Read more about Amanda Gillam