When you think of interest rates loans and credit cards are probably what come to mind. If you’ve ever seen an ad for a credit card you’ve probably heard it end with ‘23% APR Representative , T&Cs apply’.

As we discovered in the previous article, debt governs economic activity in a society, and interest rates govern debt. So what does that mean for you?

The company you work for, the bar that you got hammered from last weekend, the car you financed – they all rely on borrowed money to function in some way, and borrowing always comes with interest.

Before we dive into what that actually means for us, let’s try to understand what interest actually is (for those of you who’ve read my previous article, this example will sound somewhat familiar):

Let’s say that you wanted to take out a loan:

• You apply for a £10,000 loan and if the bank thinks that you’ll pay it back, you’ll get approved.
• The loan agreement will have a bunch of small print but most importantly, it’ll tell you:
  • How much you can borrow (£10,000)
  • At what interest rate (let’s say 10% APR).
  • The loan term which is how long you’ll be paying the loan for (let’s say 24 months or 2 years).
• The bank will put £10,000 in your bank account and it’ll be for you to use for whatever, whether it be those tedious home repairs or that fancy wedding you’ve always been dreaming of.

Ok so you got married and are back from your honeymoon. It was so much fun that you almost forgot about the fun part – paying back the loan:

• So you’ll pay the loan back in monthly instalments over 2 years, or 24 instalments. Break down £10,000 into 24 months, and you’ll expect a monthly payment of £416.67.
• But wait, hold on! The bank doesn’t let you borrow for free, so we have to factor in the 10% interest rate:
  • Remember the abbreviation ‘APR’ – that’s the annual percentage rate – it means that you’ll be charged 10% of the loan amount on top of the loan to be allowed to borrow £10,000.
  • Because you’re paying down the £10,000 loan in instalments, the amount you’re borrowing decreases every month, so calculating the interest paid isn’t quite as simple as getting 10% of £10,000, dividing by 12 and then multiplying by the the number of months.
  • You’d use a special formula to work it out, but over 2 years just under £1100 goes towards interest.
• You end up paying back the bank back the loan amount plus the interest, so a total of just under £11,000 (£11,074.80).

Ok cool, so now that we know what interest actually looks like, we can now begin to understand how it plays out for you:

Remember the very first step of getting the loan in the first place? Based on factors like your income, expenses and credit history, your bank calculated how risky you are as a borrower and decided how much you could borrow and for what interest rate.

Not all loans get paid back, people can spend more than what they can afford to pay back and default (fail to pay the loan), so by lending, banks need to take on risk.

If you have a history of not paying your bills or loans on time, you’re a riskier bet for the bank. To justify taking on that extra risk, the bank will expect a better return on their money. The interest rate on your loan would be higher than for someone who does pay their bills on time.

The key takeaway is that the higher the lender’s risk, the higher the interest rate will be.

It’s also why taking out mortgage to buy a house will cost you 4-5% whereas a credit card will typically set you back 25% – people are far less likely to default on their mortgage and risk losing their home than they are to not pay a credit card bill. It’s less risky for a bank to give you a mortgage than a credit card loan.

Avoiding most types of borrowing that banks consider ‘more risky’ such as personal loans, car finance and credit cards can be one of the easiest yet most life-changing ways you can set yourself up for financial success:

• You’ll save thousands in interest fees.
• You’ll avoid drowning in debt anxiety by spending only what you actually have.
• And by managing your money responsibly, you’ll increase your credit score, reducing your risk as a borrower which gets you access to the lowest interest rates – really handy if you need to get on the housing ladder!
• And most importantly, you’ll feel like you’ve earned every thing and every experience you’ve had.

So now that you have a basic understanding of how interest rates can affect you and your day-to-day.

However, interest rates don’t just apply to people, they apply to all kinds of borrowing, whether it’s for small businesses, large corporations, institutions and even the government. In the next part, we’ll look at the bigger picture to understand how interest rates can manipulate the very fabric of society.