How Is Loan Interest Calculated?

Here's how lenders calculate interest on your loan.

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

When you purchase a vehicle (or any other item, such as machinery) you are using finance by borrowing the money to fund the vehicle.

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

Interest is charged on the amount borrowed (the 'principal').

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.

However, 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*:

Each month's loan payment is show with a breakdown into the amount of loan repaid (the 'Principal') and the interest charged on it.

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

Interest Reduces Slowly

Notice how the interest charges reduce each month?

This is because an increasing proportion of the loan is gradually repaid over the repayment period (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 business finance agreement may be offered with a fixed interest rate of 5%.

As the loan repayments are made the amount outstanding reduces, 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 with an arrangement fee) or due to 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 typically borrow the money and incorporate this into your monthly contract hire rentals, so you are effectively paying twice - the interest that the contract hire company borrowed and a mark-up on that too.

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 avoid giving any discount on the amount borrowed, so this hidden subsidy is effectively the interest appled to the loan.

In essence, 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.

What Is An Annual Percentage Rate (APR)?

An APR is a figure that represents the total annual cost of borrowing money, including the interest rate and all other mandatory fees and charges.

APRs are designed to help consumers understand the true cost of borrowing and to make it easier to compare different loan products.

APRs are regulated in the UK by the Financial Conduct Authority (FCA) to ensure transparency and fairness in lending practices.

APRs are expressed as a percentage, allowing consumers to easily compare the true cost of different borrowing products like credit cards, personal loans, and mortgages from various lenders.

For example, an APR of 10% means that if you borrow £100, you will pay £10 in interest and fees over the course of a year.

As a comparison, an APR of 15% means that if you borrow £100, you will pay £15 in interest and fees over the course of a year.

A higher APR basically means that the borrowing will be more expensive, so you can see this in the documents provided to you for the finance.

Key aspects of an APR:

Includes fees: Unlike just an interest rate, an APR accounts for additional costs, such as arrangement fees, to give you a complete picture of the cost of borrowing.

It's a comparison tool: Because all lenders must calculate APR using the same rules, it is a standardized way to compare different financial products and find the best value.

Annual cost: The "annual" in APR refers to the cost over a one-year period, expressed as a percentage of the amount borrowed.

Legal requirement: Lenders are required by law to display the APR for the credit products they offer, making it easier to make informed borrowing decisions.

Personal APR: The specific APR you are offered can depend on your personal financial situation, including your income and credit history.

What About Personal Contract Hire?

You'll never see the interest rate in a Personal Contract Hire (PCH) agreement.

That's because PCH is technically a rental agreement and not a loan.

It means that the car or van provider buys the car and rents it to you for a fixed period of time, typically with a fixed number of miles allowed to be driven.

As such, PCH avoids the need to show an interest rate or APR.

But it does have a purpose - to help get a car for a fixed monthly payment.

There may be penalties for exceeding the agreed mileage or for damage to the vehicle, so be sure to read the terms of the agreement carefully.

But PCH does have it's place in allowing you to get a car or van for a fixed monthly payment without the need to worry about interest rates or APRs.