How and when do lenders apply interest rates to their products? It’s vital to be aware of how lenders are calculating interest, so you’re aware of the actual cost of borrowing. Lenders will apply interest on a simple or compound basis.
Simple interest vs Compound interest
The regularity at which interest charges are added to a loan principal can make a significant difference to overall repayments. Let us assume you have a £100,000 loan over 12 monthsat an interest rate of 12%.
Using the simple interest concept, at the end of the 12 months,you would need to repay £100,000 plus 12% interest, which equates to a total figure of £112,000.
Using the same loan principal and interest rate, let us assume the lender adds interest to the principal monthly. The rate usedwould be 1/12th of the headline interest rate, which in this case would be 1% per month. At the end of the first month the balance outstanding, including principal and interest figures, would be £101,000. In month two there will be a charge of 1% on the increased figure, i.e. 1% of £101,000. This equates to an interest charge of £1010. In month three there will be a charge of 1% on the increased figure of £102,010, and so on. By the end of the 12 months, the total repayment would be £112,682 which equates to £12,682 in interest charges, or 12.68% interest. This is a 5.68% increase on the simple interest rate charge and demonstrates how compound interest works. In effect, you are paying interest on a growing level of interest, each month, over the 12 months.
Simple and compound interest products
Under new regulations, lenders are now legally obliged to quote headline interest rates and annual percentage interest rates. In the above instance, the headline interest rate would be 12%. In comparison, the annual percentage rate would be 12.68%, before taking into account any additional costs.
Simple interest rates example: Car loans
When calculating the interest on a car loan, the financing company would work out the simple annual interest charge and spread the repayments over 12 months. So, each month you make repayments made up of 1/12th of the interest charge and 1/12th of the principal borrowed. After the 12 months, you would have repaid all interest and the principal borrowed.
Compound interest rates example: Credit card
Many people may not be aware, but credit card companies use the compound interest rate method. It will depend upon the terms and conditions, but this may either be on a monthly or daily basis. On a monthly basis, your credit card balance would grow by 1/12th of the annual interest charge. Those companies using a daily interest calculation would increase the credit card balance by 1/365th of the annual interest charge. This would be added to your credit card balance daily, thereby accruing “interest on interest”.
In recent years, we have seen a significant tightening of financial regulations in favour of consumers. Let’s look at loans, in particular. Lenders are now legally obliged to quote not only the simple interest rate but also the compound interest rate where applicable. The compound interest rate will also include any monthly charges that will be added to the outstanding balance.
Many people automatically assume that the difference between simple interest and compound interest is minimal. When lending significant amounts of money, this can have a material impact on overall repayments, especially with relatively long loan terms. Some financial arrangements may also include monthly charges upon which you would pay interest and interest on that interest. This can very quickly add up.