At first glance, the calculation of loan repayments can be difficult to understand, especially when you take into account set fees, etc. However, when taking out a loan, it is extremely important that you understand how the calculations are made and the impact of extended payment terms or even missed payments.
As we will cover later in this article, there are many different types of the interest rate related to loans, whether these are personal loans, mortgages or any other type of finance.
Before we look at the different types of loan interest, we will take a look at how monthly capital and interest payments are calculated and the impact of extended loan terms.
Calculating Loan Repayments
When looking at the calculation of loan repayments, we will assume a £10,000 loan with a £600 setup fee which equates to a capital loan of £10,600. In this instance, the loan APR is fixed at 12.9%, and the loan term is 36 months:
- Loan capital: £10,600
- APR: Fixed 12.9%
- Term: 36 months
In order to break down the loan repayment calculations, we need to know the monthly rate, which is 12.9%/12, which equals 1.075%. So we know that from each monthly repayment, a charge of 1.075% will be applied to the outstanding capital to calculate the interest element with the balance going towards paying off the capital.
As a consequence, the interest payment in the following month would be less because the capital remaining will have fallen. Loan companies are able to calculate a regular payment over a 36 month period which will cover both interest charges and capital repayments.
However, it is possible to set up a spreadsheet that will take into account interest on the initial capital of £10,600 plus any capital repayments and using trial and error we can arrive at the exact monthly repayment.
If we use a £360 a month repayment the plan looks like this:-
|Capital||Cap Repay||Interest||Total||New Bal|
When we get down to payment 36 we can see that we have slightly overpaid: –
By adjusting the monthly repayment, the spreadsheet will recalculate capital repayments, interest and the new balance going forward each month.
The actual repayment for this particular plan is £356.65 as you can see below:-
|Capital||Cap Repay||Interest||Total||New Bal|
After repayment 36 you can see there is a small balancing figure at which point the loan has been repaid in full:-
After repayment 36 you can see there is a small balancing figure at which point the loan has been repaid in full:-
|Capital||Term||Fixed APR||Loan||Total Interest||Loan||Total Interest|
|£10,600||12||12.9%||Capital & Interest Repayment||£755||Interest Only||£1367|
|£10,600||24||12.9%||Capital & Interest Repayment||£1482||Interest Only||£2734|
|£10,600||36||12.9%||Capital & Interest Repayment||£2239||Interest Only||£4102|
So, while an interest-only loan may have a significant beneficial impact on your short-term cash flow, this is not without cost, significantly greater interest payments!
Different Types of Loan Interest Rates
As you see below, there are a huge number of different loan interest rates available. The majority of these will in some shape or form more relate to mortgages as opposed to personal loans, but there are a lot of these which will relate to personal loans as well.
Without further ado, let’s take a look at the different types of loan interest rates available and the pros and cons.
The most common type of variable rate is the standard variable rate published by all mortgage lenders. This is basically the standard rate they offer unless customers are on some kind of special interest arrangements such as a fixed rate, etc.
Variable rates tend to come into their own when base rates move downwards as you would expect lenders to move their standard variable rate in the same direction. On the flip side of the coin, if base rates begin to increase, then the variable rate will follow suit.
While sometimes unavoidable, for example, when negotiating a new mortgage deal, variable rates do not help with budgeting in the medium to long term as monthly repayments are not fixed.
While standard personal loans, both secured and unsecured, tend to be quoted on a fixed rate all term basis, it can be different for mortgages.
While it is more common in the US to have a fixed-rate mortgage for the full term, these types of arrangements are not as readily available in the UK. While times are changing, standard fixed-rate mortgages at the moment tend to be between three and five years.
However, once the fixed-rate period has ended, nothing is stopping a borrower renegotiating a new fixed-rate term if appropriate.
Base Rate Tracker
Historically base rates have been used as a very basic tool to control lending with rates rising in more buoyant times, to discourage lending, and falling when the economy is struggling, encouraging investment.
Those who held a mortgage base rate tracker since the US mortgage crisis of 2008/9 will have seen a significant reduction in their monthly repayments.
While mortgage companies do not reduce their standard variable rate to the same degree as base rates, when linked to the actual base rate, you will enjoy the full benefits.
At this moment in time, it looks as though UK base rates could move into negative territory. However, the vast majority of mortgages will have a minimum rate set around 0% plus a premium- so those with base rate trackers won’t fully benefit from any fall below zero.
Loyalty interest rates are a very interesting concept because as the name suggests, they recognise and reward loyalty. If you dig a little deeper, you will see that banks, building societies and the likes of credit unions will offer long-term customers a discount on their traditional interest rates.
While not always a huge amount, even a relatively small shaving of the headline interest rate can make a significant saving in the longer term.
However, while a loyalty rate is always welcome, you obviously need to take into account the full services and the cost of finance provided by the company/union.
How does the cost of the overall package, even including interest rates on deposit accounts, compare and contrast with others?
Discounted Interest Rate (Discounted on a Standard Variable Rate)
While you will often hear mention of the standard variable rate (SVR), this is not a mortgage rate which many people would choose to be on. There may be situations, where due to financial difficulties in the past, there may be no option, but on the whole, you would look towards a fixed rate or some kind of capped/tracker rate.
There will be situations where you can negotiate a discount on the standard variable rate which may last for a number of years or indeed the full-term of the loan.
As we mentioned above, even a relatively small saving on the headline interest rate can equate to a significant interest payment saving in the longer term.
Those who have taken out mortgages in relatively calm economic times would probably never have envisaged the huge volatility we saw in UK interest rates on Black Wednesday 1992.
This was the day the UK retreated from the European Exchange Rate Mechanism (ERM). Initial attempts to protect the pound by increasing interest rates failed miserably, and UK base rates hit an intra-day high of 15%.
While this was obviously a short-term phenomenon, it does highlight the benefit of arranging loans with a capped interest rate. As the term suggests, this simply means that interest rates charged on your loan (most commonly a mortgage) cannot move above and beyond the cap.
It will obviously depend upon the cap rate, but this does give borrowers a degree of visibility going forward.
In recent times we have seen a growing demand for offset mortgages which are still in their relative infancy in the UK but can be extremely useful. The concept is very simple; the borrower will hold not only their mortgage but also their current account and savings account with the same bank.
They can then place regular income into an offset account and draw this down as and when required. This means that on average, the capital remaining on the mortgage will be lower.
Obviously, as funds are drawn back from the offset account, this will increase the net mortgage capital, but the client will have benefited from reduced interest. Over a typical 20 year or 25-year mortgage duration, there is potential for significant savings.
How Are Interest Rates Calculated?
We will now take a look at the way in which loan interest rates are calculated and how you can influence these.
All things being equal, it is highly likely that you will be offered a lower interest rate when borrowing a larger amount. This is simply because over a prolonged period of time, the lender will make more money, and this helps to improve their cash flow.
There are other issues to consider, such as credit ratings, etc. but we will come onto these in a moment. Obviously, enhancing your borrowings to attract a lower interest rate is not really sensible if those additional funds are not required. First and foremost, you need to work out whether you can afford the loan in the first place.
There is a general misconception that those with bad credit ratings will have no access to funding whatsoever. This is simply not true. They may have restricted access to lending, and they may be charged higher interest rates, but there are specialist lenders out there who can accommodate most needs.
Also, when it comes to credit reports and credit ratings, it is sensible to review the data held on you prior to any personal loan or mortgage application.
From time to time you may find errors on your credit report which need to be corrected, and there are ways and means of improving your rating. While overlooked by many people, the prep work in improving/stabilising your credit rating could be the difference between an approval and rejection of finance.
When looking at mortgage lending, you will often come across the LTV ratio, which is the loan to value ratio against the property you are purchasing. If for example, you have to borrow £60,000 to help fund a £100,000 then your LTV ratio would be 60%.
The average property purchase deposit is around 20% at the moment, which equates to an 80% LTV. Therefore, if your LTV is lower, this is less risky for the lender, and you should be able to negotiate a reduced headline interest rate.
Consequently, a higher LTV ratio could make the proposition riskier and therefore, a higher interest charge would normally apply.
While in many ways linked directly with your credit rating, affordability calculations are standard for mortgages, loans and other finance applications in the UK.
For example, the maximum mortgage loan available under current FCA regulations is 4.5 times your annual income or 4.5 times a joint income for a joint mortgage. In simple terms, the more affordable a mortgage is to the underlying borrower, the less risk and therefore, in theory, a lower interest rate compared to someone who has less disposable income.
The affordability factor is not so relevant for private banks, niche lenders and crowdfunding platforms which are also very prominent in the personal loan and mortgage loan markets.
There will be occasions where those with regular income are not able to fully fund a deposit on a property purchase and may require a relatively high LTV ratio. If their income was not sufficient to support the higher LTV ratio, then they can bring a guarantor into the agreement.
The guarantor would need to pass the affordability test and maybe even put up collateral against the underlying borrower’s financial commitment. As this would reduce the risk/reward ratio, it may be possible to negotiate a reduced interest rate from that which would normally have been quoted.
Anyone thinking of becoming a guarantor needs to be aware that in the event of default, they will be called upon to cover regular payments while the borrower is unable to do so.
If the guarantor experiences financial difficulties, then the collateral put up against the loan would be liquidated, the outstanding loan paid off, and surplus funds returned to the guarantor. Be careful!
Whether looking at a personal loan, business loan or even a mortgage, the greater the level of assets you can lodge against funds received, the less risky the transaction is for the underlying lender.
The concept of lending is based upon the risk/reward ratio; therefore, the greater the level of assets lodged against a loan, the greater the insurance policy in the event of default.
There are occasions where even high net worth individuals may be asset rich but cash poor and therefore, able to utilise debt-free assets to guarantee future funding.
While this may sound risky, in an appropriate environment, this allows the borrower to utilise their underused assets in the knowledge that, all being well, they will still own after the loan has been repaid.
Do Interest Rates Increase Based on Credit History?
Such is the importance of your credit history and credit rating that this is a subject which we will expand on in this section. Again, taking into account the simple risk/reward ratio associated with lending, the greater risk an individual is deemed, the higher the interest rate charged.
There are occasions where this may seem a little unfair where, for example, missed payments and financial issues within the last six years still remain on your credit file.
So, you could have experienced a bout of financial difficulty five years ago, but if you applied for credit tomorrow, those issues would still be on your file and impact your credit rating.
On occasion, some lenders will fully appreciate the “unfairness” of this system in the eyes of many. If you have been covering all of your payments and are financially secure, then you may not be penalised to the same extent as someone who is still struggling.
The majority of lenders will look at your credit rating without going into any detail, so it is in your interest to make them aware of extenuating circumstances.
For those who have a genuinely bad credit history, there are specialist lenders out there open to negotiations although these troubles will be reflected in higher interest rates.
Overpayments – Repaying Your Loan Early
In a perfect world, the vast majority of borrowers would prefer to repay their loans early. This would enhance their long term cash flow and reducing their loan interest payments. Unfortunately, it is not always as simple as that for a number of reasons:-
There will be occasions where a relatively long term loan will reduce your monthly outflow, obviously paying more interest over the loan period, but allow you to get back on your feet.
If for example, you have applied for a debt consolidation loan, there is no point whatsoever in scrimping and saving to make overpayments while building up debts elsewhere. There needs to be a balance between the term of a loan and a sensible long-term approach to repayments.
While not necessarily as common today as they were in the past, some lenders will write overpayment charges into their loan agreements. This has the effect of discouraging borrowers from making overpayments while at the same time protecting the lender’s profit margin in the event that overpayments were made.
If your finances do improve, cash flow is stronger, and you have surplus capital, then it makes sense to consider overpayments.
If you see an increase in your disposable income and are tempted to make an overpayment on your mortgage, you might wish to take a step back and look at the wider picture.
For example, you may have a mortgage attracting an annual interest rate of say 4% but at the same time credit card debt with a rate over 20% and an overdraft with a rate approaching 50%.
Surely it makes more sense to redirect this surplus income to repaying your higher interest debt?
Last but not least, the emergence of specialist lenders in the UK over the last 20 years or so continues to gather pace. In reality, whatever your financial situation, loan duration and how you plan to spend the loan proceeds, there will likely be a specialist lender out there willing to discuss terms.
Specialist lenders today include those with a particular interest in:-
- Buy to let investment
- Those with troubled credit histories
- Equity release
- Invoice factoring
- Debt management
- Foreign nationals purchasing UK property
This list is by no means exclusive, but it does give you an idea of the specialist lenders available today that can accommodate the majority of scenarios.
As you would expect, the interest rate charged by a specialist lender will reflect the underlying finances of the customer and the level of borrowings.
On the one hand, buy to let investors may receive a more competitive rate compared to those lenders on the high street. On the flip side of the coin, those with troubled credit histories may struggle to obtain finance elsewhere and incur relatively high-interest rates.
There is so much to think about when we look at interest rates and loan terms in particular. The natural instinct is to repay a loan as soon as possible, although sometimes this may not be the best approach. It pays to step back and take a broader view of your whole situation as opposed to looking at specific elements in isolation.
As a consequence, it is no surprise that many of those looking to raise funds will often employ the services of a financial adviser or a mortgage broker.
A financial adviser may give you an array of alternative solutions for your scenario while a mortgage broker will have contacts in the market and, in theory, an ability to negotiate improved terms.
It is very important that you take professional financial advice when looking at raising funds because there may be other aspects of your finances to consider.
If there is any way that you can shave even a relatively small amount from the headline interest rate, this can have a huge impact on interest paid with, for example, a 20/25 year mortgage.
How Can Flexy Loans Help?
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They have already helped thousands of people get loans already, and they can do the same for you.
Choosing a loan broker like us (we don’t charge any fees) means our application process matches you with the best loan available to you. All lenders we recommend are regulated by the FCA, which gives you an additional layer of protection.
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