When it comes to finance and lending, there’s a lot of industry jargon. All the acronyms and phrases can make taking out a loan confusing – not something you need when you’re trying to make an informed decision.
In this article, we break down some common terms into ‘plain English’ which, hopefully, will make the next finance meeting you have a little easier to navigate.
Interest is the amount of money a lender charges you to borrow their money. It’s usually written as a percentage, which is the interest rate. The amount of interest you’ll pay could vary because of factors like your credit score and the type and structure of loan you need.
While this may seem straightforward, there are different definitions and calculations of interest such as flat rate, fixed rate, variable rate, and APR. We break them down for you next.
A flat rate of interest is a simple method used to calculate the annual interest charge on a loan and the monthly instalment.
Example: If you’ve got a loan of £10,000 with a flat rate of interest of 10%, your interest charge for the year will be £1,000.
Annual Percentage Rate (APR)
The APR is the total cost of borrowing, including all fees and interest, expressed as an annual percentage of the loan amount. APR considers any repayments made during the loan term that reduces the principal outstanding.
Fixed Interest Rate
Your interest rate is fixed throughout the entire term of the loan. It’s not moving and it’s not changing.
Many borrowers prefer fixed-rate loans as they provide certainty of the amount of monthly repayment.
Example: You have been accepted for a £10,000 loan for 48 months at a fixed interest rate of 10%, despite any market changes or economic volatility that may occur, your interest rate will remain at 10% for 48 months.
Variable Interest Rate
With a variable rate, the interest on your loan could change. This is usually based on market conditions and can be unpredictable.
Take recent times as an example. Because inflation has reached record highs due to external issues like COVID-19, Brexit and the war in Ukraine, the UK Base Rate has been increasing to help curb inflation. It currently sits at 4.5%.
With Base Rate increasing, interest rates have also been increasing. Anyone on a variable-rate loan linked to UK Base Rate will have seen a steady rise in interest costs over the past two years.
So that’s interest rates. What else might you come across?
The principal is the amount of money you borrow from a lender. It doesn’t include interest or fees.
The term is the length of time you have to repay a loan. Shorter loan terms typically come with higher monthly payments, but less interest. Longer loan terms come with lower monthly payments, but more interest is paid.
The debt-to-income ratio compares the borrower’s monthly debt payments to their monthly income. The lower the debt-to-income ratio, the more likely a borrower is to be approved for a loan.
Default occurs when you fail to make the required payments on a loan. This can lead to overdue payment fees and charges, damage to your credit rating and potential legal action from the lender.
Collateral is the term used to describe the security against your loan, such as your car, house, machinery, or stocks/shares. If you fail to repay your loan, your lender can take possession of these assets to recover any money owed.
The loan-to-value ratio is a measure of the amount of the loan compared to the value of the collateral. Lenders use this ratio as an indicator of the potential risk of the loan. Generally, the lower the loan-to-value ratio, the lower the risk of loss to the lender, should they take possession of the collateral in the event of default.
Example: If a borrower is seeking a £100,000 loan and pledges collateral worth £150,000, the loan-to-value ratio would be 67%. You can use this brilliant online calculator to see your loan-to-value ratio.
A secured loan is a loan that’s backed by collateral. Secured loans typically have lower interest rates than unsecured loans, as they typically carry less risk for the lender.
An unsecured loan is a loan that is not backed by any collateral.
These loans are typically higher risk for the lender as they have no collateral to fall back on if the borrower doesn’t pay. As a result, unsecured loans generally have higher interest rates than secured loans.
Your credit score is a numbered rating of your creditworthiness. This number is based on your credit history including factors like how much debt you have, whether you pay your bills on time and how long you’ve had credit accounts open.
Lenders use your credit score to determine how reliable you are when it comes to repayments. A higher credit score generally makes it easier to get loans and may mean you’ll be offered lower interest rates and better terms.
By understanding these key terms, consumers in the Channel Islands can make more informed decisions when borrowing money. Always read the terms and conditions of any loan carefully before you sign up and if you’re unsure about anything, don’t be afraid to ask questions. A reputable lender will be happy to explain any jargon or terminology you don’t understand.