Understanding interest rates
Two offers can quote the same percentage and cost thousands apart. This is how to tell which is which — in about six minutes, with no maths beyond multiplication.
The rate is the rent on the money
Interest is what you pay for the use of somebody else’s money over time. Two things drive it: how risky you look, and what money costs the lender in the first place — which is largely set by the Bank of England What this meansThe interest rate set by the Bank of England. Most lenders price their own rates from it, so when it moves, borrowing costs usually follow..
Everything else — fixed, variable, flat, APR — is a description of how that rent is calculated and when it can change.
Certainty versus flexibility
A What this meansThe interest rate stays the same for an agreed period, so your payments do not change even if the Bank of England moves rates. holds your payment steady for an agreed period. You are buying predictability, and you usually pay a little for it. If rates fall, you do not benefit; if they rise, you are protected.
A What this meansThe interest rate can go up or down, usually tracking the Bank of England base rate. Payments can change month to month. moves with the market. Payments can fall — and can rise, sometimes sharply. It suits borrowers with room in their budget, or those who expect to repay early.
| Question | Points to fixed | Points to variable |
|---|---|---|
| Could you absorb a payment rise of 20%? | No | Comfortably |
| Do you plan to repay early or refinance? | Unlikely | Quite possibly |
| Is budgeting certainty worth a small premium? | Yes | Not really |
Flat rate is not what it sounds like
This is the one that catches people out, particularly in What this meansPaying for equipment or vehicles over time instead of all at once. The item itself usually acts as the security, so you may not need to put up anything else. and short-term business lending. A What this meansInterest charged on the full original amount for the whole term, even as you pay it down. A 5% flat rate is roughly twice as expensive as a 5% rate charged on the reducing balance — always ask which one you are being quoted. charges interest on the whole original amount for the whole term, even as you steadily pay it down.
Borrow £20,000 over 3 years at 5% flat and you pay £1,000 a year in interest for all three years — £3,000 — despite owing far less by year three. The equivalent rate on the reducing balance is closer to 9–10%. The APR is the honest comparison, and you are entitled to ask for it.
Which number to compare
For consumer borrowing, the What this meansThe yearly cost of borrowing, shown as a percentage. It includes the interest plus most compulsory fees, so it is the fairest way to compare two offers side by side. is designed for exactly this job: it folds in interest plus most compulsory fees and expresses it as one annual figure. Comparing APR against APR is comparing like with like.
For business lending, APR is not always quoted. The reliable substitute is the total amount repayable over the full term, including every fee. If a lender will not put that in writing, that is your answer.
Five things to get in writing before you sign
- The total amount repayable, in pounds
- Whether the rate is flat or on the reducing balance
- Arrangement, documentation and broker fees
- Any What this meansA fee for paying an agreement off ahead of schedule. Worth checking before you sign if you may want to repay early or refinance.
- Whether a What this meansA larger final payment at the end of an agreement. It keeps monthly payments low, but you need a plan for how the final sum gets paid. falls due at the end
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