What are Interest Charges?

When you purchase a vehicle using finance you typically pay for the facility of borrowing the money to finance the vehicle.

Interest is the lender's charge to you for borrowing the lender's money.

The rate of interest you pay for borrowing will vary according to the type of finance agreement, the item you buy with the finance and the lender's view of your ability to repay the loan.

Interest is charged on the amount borrowd (the 'principal') and remaining unpaid on a loan so, for example, if interest is charged at 5% a year on a loan then you will pay 5% a year on the unpaid balance of the loan.

As you make the monthly repayments of the loan the amount outstanding reduces and so do the interest charges.

Here's a simple example of a loan of £10,000 repaid at the end of each month over 12 months at an interest rate of 5%pa*:

Month Principal Interest Payment
1 814.40 41.67 856.07
2 817.80 38.27 856.07
3 821.20 34.87 856.07
4 824.63 31.44 856.07
5 828.06 28.01 856.07
6 831.51 24.56 856.07
7 834.98 21.09 856.07
8 838.46 17.61 856.07
9 841.95 14.12 856.07
10 845.46 10.61 856.07
11 848.98 7.09 856.07
12 852.57 3.55 856.12
10000.00 272.89 10272.89

* Compounding and annualisation of the interest rate has been ignored for simplicity.

Notice how the interest charges reduce each month as an increasing proportion of the loan is gradually repaid over the repayment peried (known as the 'term').

Interest charges on a loan may be 'direct' or 'indirect', depending on the type of finance agreement.

What Are Direct Interest Charges?

Direct interest charges are those expressed openly in a finance agreement, such as a fixed or variable annual interest rate on the funds borrowed.

For example, a finance agreement may be offered with a fixed interest rate of 5%.

As the loan repayments are made the amount outstanding reduces and so the interest charges reduce too, until the loan is finally repaid and the interest charges stop.

What Are Indirect Interest Charges?

Indirect interest charges are those which are hidden in the terms of a finance agreement because of either the type of agreement (e.g. a contract hire agreement rather than a loan) or the structure of the finance (e.g. a 0% finance deal).

For example, when you obtain a car through contract hire you are effectively renting the car for a period of time.  The contract hire business supplying the car to you still needs to buy it in order to provide it to you.  To fund the purchase they borrow the money and incorporate into your monthly contract hire rentals the interest charges that they pay to finance the car.

Similarly, if you finance a car on a 0% interest deal, the business that lends the money to you to buy the car still needs to be paid for the borrowing facility.

It's therefore likely that the 0% finance deal will apply to a fixed price for purchasing the car.

You probably could have negotiated a discount on the purchase price if you didn't take the 0% finance deal, but instead of giving that discount to you the supplier of the car gives it to the lender instead.

This way the lender gets its payment for lending the money in an indirect way - through receiving the 'lost' discount you could have negotiated, which is effectly an indirect interest charge on the car finance deal.

Indirect interest charges can also apply through any finance arrangement, application or documentation fees charged to you in order to obtain the loan agreement.