Borrowing guide - what is interest

The UK interest rate of a (UK) loan is the cost of the loan or cost of the capital.

It is separate from the cost of the administration fees, etc, that may be charged for setting up, administrating and finally closing the loan account.

It is quoted in percentage terms. However, interest rates may be applied in two ways - simple interest and compound interest.

Simple interest means that you only pay interest on the capital borrowed.

Compound interest means that you pay interest on the capital borrowed as well as interest on any interest that is due.

Consider the following example of a loan for £1000 for one year (12 monthly installments) at 12%pa.

If simple interest was applied to this loan you'd pay back £1000 x 112%, i.e £1000 capital + £120 interest, which works out at £93.33 per month.

If compound interest was applied to this loan, you'd pay £1000 x 112%pa x 112% (approx), i.e. £1000+ £120 + £134.40 interest (approx), which works out at £105 per month (approx).

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