How Different Types of Interest Impact Your Credit
If you’re building credit or applying for a credit card or loan, you’re probably hearing a lot about different types of interest. It’s easy to get overwhelmed when talking about interest and how it works. In fact, with all of the different terms like APR and AER, it sometimes seems like they are trying to confuse us all. However, understanding the different types of interest is important because it will determine the size of your monthly payments and more. More manageable interest payments can make credit building easier, while interest that grows out of control can leave you owing more than you can afford.
In this blog, we’ll provide clarity to help you understand the different types of interest, how they impact your credit, and what to pay close attention to. Let’s get to it!
Interest Explained Simply
Interest is essentially the cost of borrowing money. For example, when you receive a credit card or mortgage for a house, the lending institution isn’t simply trading you their money now for your money in the future; they’re selling it to you for the cost of interest.
The Two Main Types of Interest
The two most common types of interest are simple interest (or nominal interest) and compound interest. The differences between these two are significant, so let’s take a closer look at them.
Simple interest is, well, simple. It applies to the initial loan amount and remains static for the loan’s lifetime.
For example, if you borrowed £10,000, had a 5% interest rate, and made no payments in the first year, you would owe £10,500—that’s an additional 5% (or £500) added on to the initial loan amount.
Compound interest is where things get complicated and can be confusing. Compound interest is based on your total balance, including the total interest. For example, using the same terms as above (£10,000, at a 5% interest rate) you’d accumulate the same £500 in interest in the first year. However, in the second year you would accumulate £525 in interest, as it accrues based on the new total (£10,500), which includes the previous interest. This is opposed to simple interest which is based only on the initial loan amount.
Credit card interest is typically compounded, although instead of being compounded yearly, like in our earlier examples, credit card interest can be compounded as often as daily. This means credit card interest can grow quickly, which is why many people struggle to get out of debt.
Read more: How to use a credit card wisely
APR vs AEY- Which Should You Use?
To determine whether a product will either help or hurt your credit score, you need to understand the different ways interest is calculated and represented. Let’s take a look at some of the most common ways this is done.
Your credit’s annual percentage rate (APR) refers to the interest that is applied to purchases. The APR will also be applied to the interest that you’ve previously accrued, although it doesn’t represent that upfront.
Related Read: What is a Good APR for a Credit Card in the UK?
AER stands for annual equivalent rate, which is sometimes referred to as the effective annual interest rate. AER differs from APR in that it reflects the impact compounding interest has on your existing interest. Therefore, you can think of AER as the real interest rate.
How Should I Calculate My Interest Rate?
Higher interest rates can negatively impact:
- Your ability to make timely payments
- Your credit utilisation ratio
- Your credit rating
Therefore, when you’re applying for a credit card or loan, always calculate your AER rather than relying on the APR provided by the lender. You want to do this because it will give you a full picture of how interest will actually accrue when compounding is taken into account.
Common Interest FAQs:
Why Don’t Lenders Advertise AER?
You’ll notice that when you’re shopping for a loan or a credit card, lenders will almost always advertise APR. The reason is simple: APR is a smaller number, and is therefore usually less intimidating to borrowers. You might be less likely to use credit as frequently if a big, scary AER—the more accurate way to measure the impacts of interest—is attached to each purchase. The providers essentially use APR for marketing purposes.
Related read: What is Representative APR and Why is My APR Higher?
What Impacts My Interest Rate?
Your interest rate can be impacted by a number of things, but some of the largest factors include:
- Credit score: A higher credit score will typically result in you receiving a more favourable interest rate.
- Payment history: Payment history is one of the largest factors that impacts your credit score and is very important to lenders. A record of inconsistent payments won’t help your chances of receiving the best interest rate possible.
- Other negative marks on credit report: If you have marks like a CCJ or a default on your credit file, lenders might be less willing to extend a line of credit to you. If they do, it might come with an interest rate that is higher than you hoped for.
Building Credit Can Be Confusing—Pave Makes it Easier
Understanding the terms of your loans and credit cards is essential for being able to make the timely payments that help build your credit. If you don’t, the impacts of high interest rates can sneak up on you and leave you in debt.
Fortunately, the Pave App can help. With bills monitoring that helps you make timely payments, personalised credit fixes, and active credit building, over 90% of our customers have improved their credit score.