Interest rates explained

Interest rates are vital to understand when it comes to getting finance for your business. They determine how much it costs you to borrow, and change depending on how long you want to borrow for. Interest rates can be calculated in a variety of ways, so to make sure you’re not comparing apples with oranges, take a look below at the different terms and what they could mean for your business.

What is an interest rate?

When taking a loan, the lender will charge you interest on the loan amount. The interest rate simply states how much interest they will charge. A very basic example could be:

You take a loan of £1,000 over 12 months

Your interest rate is 5% per year

5% of £1,000 = £50

Here you would pay £50 interest on your £1,000 loan. However, this is just an example to show you how percentages work, and in practice, the interest you pay is more complicated to calculate (more on this below).

The lender may also charge fees, such as an arrangement fee or annual servicing fee. Together with your interest, these make up the cost of taking a loan.

What affects your interest rate?

A key factor in determining your interest rate is the amount of time you want to borrow for. You can reduce your monthly repayments by choosing to repay over a longer period, which could make borrowing a large amount more affordable. However, usually the longer you borrow for, the higher your interest rate will be. Finding the balance between affordable repayments and adding to the cost of finance is important to making the right choice for your business.

The other key factor is how creditworthy your business is. When you apply for a loan, the lender will perform a credit assessment. The better equipped they believe you are to repay the loan, the lower your interest rate could be.

The combination of your credit rating and loan term defines the interest rate you’ll pay.

How does compound interest work?

Compound interest can make a huge difference to the cost of borrowing. Typically interest is added on a monthly or yearly basis, and is calculated on the amount you have outstanding at that time. For example:

You take a loan of £10,000 at 5% per year, but don’t start making repayments yet.

Year 1

Interest added = 5% of £10,000 = £500

Total outstanding = £10,500

Year 2

Interest added = 5% of £10,500 = £525

Total outstanding = £11,025

Year 3

Interest added = 5% of £11,025

Total outstanding = £11,576.25

You can see the amount of interest that gets added each year goes up, as you are effectively paying interest on your interest. This is what is meant by compound interest.

Different interest rates – what they mean

APR – Annual Percentage Rate

APR includes both the interest rate on your loan and any fees the lender charges, such as annual servicing fees. The idea is that it provides a quick indication of the total cost of your borrowing, rather than having to get a breakdown.

However, using APR has some drawbacks. Firstly, it can be confusing if you have a variable rate loan. For example if you have a 25 year mortgage at 7% APR, you may start with a fixed 4.5% for 2 years followed by 7.2% variable from then on. The 7% APR takes the average plus fees, but it may never be the rate you actually pay.

The other issue is that you may not get the advertised rate. When a lender states a loan has  10% representative APR, that means that 51% of customers they approve will get that rate. The other 49% could get something different.

AER – Annual Equivalent Rate

When borrowing, AER shows the rate after interest is paid and compounded for each year. Unlike APR it doesn’t incorporate fees, so you need to include them in your calculations if you’re quoted a rate in AER.

Flat rate

Whereas APR and AER are calculated on the amount outstanding, with a flat rate the interest is charged on the original amount borrowed. So if you borrow £10,000 over 5 years, even on your last repayment you could be paying interest on the full £10,000. Typically they offer a lower rate to make it more appealing, but the total cost is far higher.

Fixed rate vs variable rate

Fixed rate loans simply mean your rate won’t change over the lifetime of your loan. Variable rate on the other hands means it could go up or down in the future. Pretty straightforward, but it’s important to note the type of loan you’re getting so you can plan for the future.

Base rates and the Bank of England

The Bank of England sets the base rate for borrowing and saving. After a decade of historically low rates, in November 2017 they raised the rate by 0.25%, the first raise since 2007, and further rate rises are expected in 2018.

Banks and other lenders will usually adjust their interest rates in line with changes to the base rate. If you have a variable rate loan and the base rate goes up, your interest rate will likely go up as well. Fixed rate loans, however, are not affected.

How does it work at Funding Circle?

All loans at Funding Circle are fixed rate. By knowing exactly what your repayments will be each month, you can make plans for your business more effectively. Our rates start from 4.5% per year AER, with a one-off fee when you take out your loan.

There are no early repayment fees, so if you would like to pay off your loan in one go, you’ll only pay interest on the time you borrow.

Amortizing loans

All Funding Circle loans are amortized. This means that you gradually pay of the original amount borrowed (the principal) each month, along with some interest. They differ from some lines of credit such as credit cards, where you may just pay off interest each month, or property loans where you pay off the principal in one go at the end of the loan.

As the interest you calculated is on the amount you have outstanding, it diminishes as a proportion of your repayments over time. Here’s an example of repayments for an amortizing loan. The total paid each month stays the same, but the principal paid each month goes up as the interest goes down.

To see more on how amortizing loans work, try this amortizing rate calculator.

To find out your interest rate, you can get a free, personalised quote in 10 minutes at fundingcircle.com/businesses.