Interest rates represent, quite simply, the cost of borrowing money. When consumers receive interest on savings and other sums of money deposited with a bank, it is because they have effectively lent money to the bank, for which the bank is paying a small amount of money. When a consumer or a business borrows cash, the interest rate is the price they are paying in order to have access to that money.
A person taking out a loan of $1,000 at an annual interest rate of 10% is effectively paying $100 a year for that money.
Interest rates get more complicated because of compound interest. Essentially, in addition to the cost of borrowing an initial sum, interest accrues on the interest already earned, compounding the debt. So after one year, our person taking out a loan of $1,000 at 10% will owe $1,100. But at the end of a second year, they will be accruing interest not just on the original $1,000 loan, but on the previous year’s $100 – an additional $10. So at the end of a second year, the debt will be $1,210.
This additional $10 might look insignificant at first glance, but compounding can accelerate debt at a frightening rate. The seminal moneysavingexpert.com site contains a handy graph to show how compound interest can boost savings, but if applied to loan interest, it makes for scary reading.
Compound interest is one more reason why it is essential to stick to schedules on loan payments to avoid debts spiralling beyond a borrower’s easy control.
It is important to understand interest rates, however borrowers should also pay close attention to the APR when taking out any loan, as this is a more accurate reflection of a loan’s actual cost. The Annual Percentage Rate includes both the interest and also the cost in percentage terms of any additional charges such as arrangement fees.
Interest rates are fairly easy to understand as long as the borrower (or indeed lender) remembers the concept that the interest represents the cost of the money. Compound interest can be difficult to calculate over more than a couple of periods, particularly when the effect of repayments is taken into account, but there are numerous tools available online to make compound interest payment calculations in order to give consumers a better idea of the scale of financial commitment which they are considering.