Interest rate or rates, can be defined as:
The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). The assets borrowed could include, cash, consumer goods, large assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to the borrower, for the asset’s use. In the case of a large asset, like a vehicle or building, the interest rate is sometimes known as the “lease rate”. When the borrower is a low-risk party, they will usually be charged a low interest rate; if the borrower is considered high risk, the interest rate that they are charged will be higher.
If you need a loan or to borrow money, one question that should be asked when applying for a loan is, what is the interest rate on the loan?
How much interest are you going to be paying on the money you are borrowing, and how is the interest calculated.
The lender is obligated by law to show a “representative APR” for all advertising of loans.
A representative APR is to “reflect at least 51% of business expected to result from the advertisement.”
This is to give you an idea of what interest rate you may receive prior to applying for the loan.
So what is an APR or the APR??
APR stands for annual percentage rate.
APR by definition is:
Is the annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.
This is how much the loan is going to cost you over a period of time, in this instance 12 months.
This is one reason why payday loans seem to carry such a high interest rate. The interest rates on these loans are high, but when expressed as an APR, they are 1500%, or higher, 2000%.
Payday loans are short-term loans and are to be paid on the borrower’s next payday. By taking the interest charged for that short period and expressing it as an APR, over a 12 month period, it causes the rate to seem very high.
Credit Scoring and Interest Rates
As previously mentioned in the actual definition of an interest rate, borrowers that are a low-risk, will receive a lower interest rate. Those borrowers that are deemed a high risk, they will receive a higher interest rate. This is to offset any losses a lender may experience by lending high risk or poor credit loans.
Good Credit = Low Interest Rate
Poor Credit = High Interest Rate
As to how banks and lenders determine who is a high risk and who is a low-risk is done using various factors, and one is the borrower’s credit score.
Low credit scores can mean a borrower would receive a higher interest rate.
Different lenders are going to have different thresholds or tiers of how high a credit score must be prior to granting the loan, and also various credit score tiers that may be tied to different interest rates.
The whole reason behind interest rates is for the lender to make money. It does a bank or lender no good to just have people place their wages and savings in the bank to just let it sit there.
By granting loans the bank can earn money back in the form of interest.
Banks pay interest on deposit and savings, but you will always note that the amount paid in interest for these accounts, is usually lower than the interest rates charged for loans.
This is one way banks make money.
Negative Interest Rates
As mentioned banks charge interest rates on loans to make money, but who would pay interest or negative interest rates, to have money in a bank.
Yet, that is what can happen depending on a few circumstances.
Just recently NatWest and Royal Bank of Scotland sent out letters to their business and commercial account holders, all 1.3 million of them, warning that if “market conditions change”, they could be charged to keep their accounts.
The letter stated, “Global interest rates remain at very low levels and in some markets are currently negative. Dependent on future market conditions, this could result in us charging interest on credit balances.”
Will this change be passed on to individual account holders, time will tell, for now it is just the commercial banking sector, and just these two banks.
But why would they do this, charge for an account??
Just as we put money into a bank, banks also put money in a bank, a central bank. That central bank here in the UK is the Bank of England.
When the economy slows down, and people don’t borrow or are afraid to borrow, the central banks can lower overall interest rates they may pay to the banks that have surplus money in their accounts with that central bank.
It is this lowering of the interest paid to the banks that is to spur them into lending money out to borrowers to make more money. Money sitting in the central bank earning a low interest rate does the banks no good. And in some instances the central bank may impose negative interest rates to really get the banks in gear and lending money.
It is thought that by lending money into the economy, the economy will rebound and grow.
What NatWest and RBS are telling their customers is, if the Bank of England cuts the current 0.5% interest rate to zero, or below, they will be passing that cost onto their customers.
Which is exactly the opposite of what reducing the interest rate is to do.
The Governor of the Bank of England Mark Carney has stated he doesn’t believe “negative interest rates work” as they punish banks, who then pass the costs onto their customers, which weakens the economy.
He is however under pressure to do something.
Considering the current climate of banking and interest rates, for now things are on hold as to us seeing negative interest rates. However, if NatWest and RBS do begin charging for accounts, with 1.3 million commercial account holders, even a few pounds a month will add to their bottom line.