Throughout life we encounter this phrase: ‘loan’. If you want to start a business, attend university or buy a car chances are that you’ll come across the option of paying for these via a loan.
What is a loan? In short: where a person borrows money from someone, typically a bank, agreeing to pay it back at a later date. Normally, this involves the borrower paying back more than they originally borrowed and this extra cost is known as interest.
Why would a person want a loan?
What a person would borrow money for differs. Normally, it’s because the person wants to buy something and doesn’t yet have the money to afford it.
This is the idea behind business loans: someone might have an idea for a business but might not have enough money to pay for the things which they need to set it up (e.g. equipment, a shop/office/factory/land). They would borrow some money, buy the things they need for the business and then when and if that business begins to make money, the idea is that the borrower would have made enough money to pay back the loan including the interest. This is the ideal and doesn’t always end up that way, since if the business fails the person still has to pay back the money they borrowed. As a result we can see that there is risk involved with getting a loan to start a business.
Likewise, a person can get a loan for a large purchase that they can’t normally afford, like a car or house. This means that they can get the product now and then pay for the item over time. The result is that because of interest the person will pay back more at the end of the loan than if they paid directly for the purchase without a loan (although this would require the person to have enough money to pay for the item directly).
Because of the risk involved with taking out and repaying a loan, some people may encounter financial difficulties as a result. If you find yourself struggling to keep up with repayments, you may find the information about managing and getting out of debt on Citizens Advice or similar services useful.
The amount of interest a person must pay back is determined by the interest rate.
For example, if Person A borrows £5 from the bank for 1 year at a 10% interest rate the amount Person A will have to pay back would be £5.50. This is because 10% of £5 is 50p and we add that on top of the original amount borrowed: £5.
There are two types of interest rates: simple interest rates and compound interest rates.
Simple interest rates work out the amount of interest based on the original amount borrowed and then adds that same amount of interest on top regularly over a certain period of time, for example, every year for 5 years.
To demonstrate, let’s say Person B borrows £10 for 10 years at 10% simple interest. Every year, we take 10% of the original borrowed amount: £1, and add it onto the total Person B has to pay back after 10 years. So adding £1 a year for 10 years means that we should add £10 interest on top of the original borrowed amount of £10.
Compound interest rates work out the amount of interest based on the amount borrowed up to that point and then adds it on to the amount a person must pay back. This is done again at regular intervals, such as every year.
To illustrate, let’s say that Person C borrows £10 for 10 years at 10% compound interest.
For the first year, we take 10% of the total the person has to pay back so far (also known as the outstanding amount or debt), so 10% of £10 is £1, and add that onto the outstanding amount, giving us £11 that the borrower must pay back.
Now for the second year, we take 10% of that outstanding amount so far, so 10% of £11 is £1.10. We then add that onto the outstanding amount, meaning the borrower has to pay back £12.10 so far. After 10 years of repeating this, the original borrowed amount of £10 has had £15.94 added onto it through interest, meaning the borrower must pay back £25.94 in total.
APR: what is it?
APR stands for Annual Percentage Rate.
This is the amount that’s added on each year that a person has an outstanding loan. The difference to interest rates is that APR takes into account the other costs that might come with getting a loan in addition to the interest rate.
Normally you’ll see the phrase ‘representative APR’ displayed next to a loan. This is because the actual APR can be different for different people – the APR will be higher for those who the lender sees as a greater risk (in other words, people who are less likely to pay back their loans on time) thus the representative APR is a representation of the rate that at least 51% of borrowers will get.
It is a legal requirement for lenders to state clearly what the representative APR is.
Original article by Overdraft.com. All rights reserved.
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