In a nutshell, interest is the price you pay for borrowing money. It’s also what you earn from your savings. It helps to determine how much you’ll end up paying for just about anything that involves borrowing, including cars, homes, and credit cards. Of course, this is a simple interest definition as there are many different types of interest, as we will cover in this article.
Here’s an example of interest when you take out a form of loan, like a credit card or a mortgage.
You sign a contract agreeing to repay the total amount of what you borrowed, plus interest. That’s like me saying I will lend you £100, but you have to pay it back with an interest rate of 1%, which means you need to pay me back £100 + 1%, which is £1. It’s easiest to remember this as how banks and credit providers make money from lending money. You’re paying back the amount you need, plus the interest rate.
But there’s more to it than that. Interest can be simple or compound, and it can be fixed or variable. It can be paid monthly, quarterly, or even all at once. And the list goes on. There are actually plenty of different types of interest. Yes, this can feel confusing, but we’ll jump into these later on in the article.
The most popular kind of interest you’ll come across is a variable rate, which can change over time, which means that your payments could go up or down as a result. Depending on which country you’re in, variable rates will depend on things like the inflation rate and the Bank of England Base Rate (where your variable rate is linked to this.
If you’re in the US, variable rates will be based on the Prime Rate, but these are the basic interest rates set by lenders to define what they think is a fair rate. Remember, if you take out a loan, you’ll pay for the loan through your interest, but you can also earn money from the interest rate of your savings account.
The most common type of interest for car loans is a variable interest rate. In fact, the interest rates of car loans can vary daily, although this is uncommon, with rates usually changing only a few times per year. According to Business Insider, a typical rate for a car purchase loan is between 4 and 8%. However, this can vary widely depending on who the loan’s provider is and the current conditions of the market.
For mortgages, the most common interest type is a variable rate. This is because most mortgage products usually fall onto the lender’s standard variable rate (SVR) at the end of a promotional period where the interest rate may be fixed or discounted.
Below, we will break down the main interest types and what you should know about them.
1. Fixed interest type
A fixed interest type remains the same throughout the fixed rate term, often 2-5 years.
An example of a fixed interest type would be a mortgage. With a mortgage, you (the borrower) agree to make regular payments to the lender over a set period of time, known as the mortgage term. The interest rate is “fixed” for a set period, meaning it will not go up or down.
Take a 30-year interest only mortgage for £100,000 at an interest rate of four percent. This means your annual interest would be £4,000.
2. Variable interest type
Whereas the prior type of interest is a set rate, so you know exactly what you’re paying, a variable interest type, as the name suggests, changes over time.
For example, if the agreed interest rate is 3.95%, a bank could set its variable interest rate at 3.30%. However, the next month, the base rate could change to 4.1%, and the variable rate could rise to 3.45%.
An example of this could be taking out a loan for £10,000 with a variable interest rate of 3%.
If you take out a loan for £5,000 over five years at a variable interest rate of three percent, your monthly repayments would be £93.22, and you would pay back a total of £5,593.20. This includes the £5,000 you borrowed, plus £593.20 in interest.
If the interest rate changes to five percent, your monthly repayments would increase to £96.30, and you would pay back a total of £5,775.60. This includes the £5000 you borrowed, plus £775.60 in interest.
3. Annual Percentage Rate
An annual percentage rate (or APR) is the total cost of a loan, including both the interest rate and any other associated fees. This is usually displayed as a percentage and will be charged annually.
For example, if you take out a loan for £5,000 with an APR of 20%, you will be charged £1,000 in total interest and fees over the course of the year.
APR is a standardised measure that is used to make it easy for borrowers to compare the cost of borrowing easy, even where interest and fees vary wildly.
4. Prime interest type
This is the rate of interest set by banks for their best customers. Typically, it would be the rate at which a commercial bank would charge to their most financially strong customers, such as large, profitable corporations.
It’s not just a single rate, but rather a range that banks will offer their best customers. The prime interest type can change over time and is influenced by the base rate.
For example, if the base rate is 0.50%, a bank’s prime interest rate could be two percent, whereas standard customers would be charged three percent.
The best way to think of the prime interest type is as a starting point for other, more specific types of interest rates.
5. Discounted interest type
A discounted interest rate is lower than the a lenders standard variable rate, and it’s what a bank will offer its customers for a specific period of time as a promotional deal. This can be used as an incentive to encourage customers to borrow money or take out a loan with the bank.
For example, if a lenders standard variable rate is 3%, a bank may offer its new customers a discounted interest rate of two percent for 2 years.
Discounted interest rates are typically used for short-term borrowings, such as a car loan or personal loan, and are also commonly offered on mortgages.
6. Simple interest type
Simple interest is a type of interest that’s only charged on the principal or the initial amount of money borrowed. It’s not compounded, which means that interest is not charged on interest that has already been applied to the loan.
For example, if you borrow £100 at a simple interest rate of five percent, you will be charged £5 in interest over the course of a year. This includes the £100 you borrowed, plus £5 in interest.
Simple interest is often used for short-term loans, such as a personal loan or car loan as well as mortgages.
7. Compound interest type
Compound interest is a type of interest that’s charged on the principal amount, as well as any accumulated interest. This means that the interest is added to the principal amount and then charged again.
For example, let’s say you took out a loan for £100 with a 5% interest rate, your payments would look a little like this;
Month 1 – (Starting Balance) £100 + (Interest) = £105
You make a payment of £10, so you’re remaining balance to pay is £95
Month 2 – (Starting Balance) £95 + (Interest) = £99.75
You make a payment of £10, so your remaining balance to pay is £89.75
Month 3 – (Starting Balance) £89.75 + (Interest) = £94.23
8. Public interest
Public interest is the welfare of the general public and society and while it isn’t a type of financial interest, public interest does impact the financial position of the public. Financial markets act in the public interest and is at the forefront of decisions made by governments, regulators and institutions.
How do types of interest and loan align with each other?
There are different types of interest rates, and each one usually aligns with specific loan types. For example, simple interest is often used for mortgages and loans, while compound interest is often used for revolving credit such as credit cards and overdrafts.
Therefore, a car loan could be either a short-term loan or a long-term one, depending on what repayment plan you typically choose, whereas the vast majority of mortgages will be long-term.
Why does Interest rate differ from interest type?
Interest rate type is different from interest type in terms of how often the interest is compounded on the borrowed money.
The most common types are simple, compound, and continuous compound interest types. What’s more, how the interest is calculated will also be variable, for example, whether it’s changed or compiled on a daily, monthly, or yearly basis.
Either way, the percentage will change. These work by being applied to the loan’s outstanding principal each year. The amount of time that the interest is charged for will also differ, which can be daily, monthly, or yearly.
However, on top of all this, an interest rate definition can differ on variables like the consumer’s individual credit score.
For example, a person with an excellent credit score will get approved for loans with lower interest rates than someone with a poor credit score. This is because the lender is taking on more risk by lending money to someone who may not be able to repay it.
So, when you’re shopping around for a loan and looking into interest rates, be sure to ask about the interest type, too, so you know exactly what you’re getting into and how much you’re going to be paying.