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Banking and borrowing

How do interest and charges work?

Applying for credit (borrowing money) is confusing. Added interest and charges can make debt grow quicker than expected too. But how does interest work? And how can you stay on top of it before it becomes a problem? Read our guide to interest and charges.

Quickly find what you are looking for


  1. What is credit
  2. What is interest?
  3. How interest rates work
  4. What charges you might see
  5. Useful tools
  6. Credit jargon explained

What is credit?

Credit makes it possible to borrow money and pay it back over time. When you borrow money, you are called the ‘borrower’ and the person or company giving you the money is called the ‘lender’.

There are lots of different types of credit. Such as loans, credit cards, mortgages, car finance and overdrafts. You can find out more about what these are and how they work later on in this guide.

What is interest?

Getting credit comes with a cost, literally. Interest is the amount added on top of what you borrow. Think of it as the 'fee' you have to pay to borrow money.

You will pay back the interest as well as paying back the original amount lent to you.

It is usually shown as a yearly percentage (%) of the amount you borrowed. This percentage is supposed to help you understand how much it will cost you to borrow money.

But, interest is included in the amount you are asked to pay back each month instead of being added at the end of a year.

A quick example:


  • You borrow £1,000 with a yearly interest rate of 10%
  • This adds an extra £100 in interest in a year
  • You will pay back a total of £1,100

If there is a 0% interest rate, it means there is no interest to pay.

 

Interest rates are also a helpful way to compare which offers and products are right for you and affordable. There are a lot of different types, so it is important to only compare when they are the same type. For example, APR should only be compared with APR.

Compound interest

Compound means interest is added on top of existing interest.

The amount of interest you owe is worked out on the total amount you have in your account, including any interest added before. This is called compound interest. As the amount you owe grows, the amount of interest you pay does too. It can make a huge difference to the amount you owe.

A quick example:

You borrow £1,000 with an interest rate of 10%.


  • At the end of year 1, you are charged interest on the £1,000. You now owe £1,100
  • At the end of year 2, you are charged interest on £1,100. You now owe £1,210
  • At the end of year 3, you are charged interest on £1,210. You now owe £1,331

How interest rates work

The Bank of England sets an interest ‘base rate’ for the whole of the UK. Lenders and banks use this to decide the interest rate they want to charge their customers. They are allowed to charge more if they want to.

The base rate is just one part of how interest rates are set by banks and lenders.

Other parts include:


  • A borrower's credit score
  • How long the money is borrowed for
  • What the money is being used for
  • The risk the loan will not be paid back in full

They decide how risky it is for them the lend the money. This is why you will see different lenders offering such different interest rates.

And there are different types of interest for different products, like credit cards, loans and mortgages. Each one will have different lengths of time to pay back what you owe, and different interest rates.

Fixed interest

Fixed means it stays the same.

It can be fixed for the full length of the agreement. Such as, a loan for 3 years at 12% interest each year.

Or it can be fixed for some of the time. Such as a credit card offering 0% interest for the first year only.


Variable interest

Variable means it can go up or down.

That is great if the base rate goes lower because your interest rate may also be lower. But you will pay more interest if the base rate gets higher.

You usually hear about variable rate mortgages. But credit card interest can also be variable.

How interest works...

Interest is shown as a percentage of the money you borrow on a credit card. You will usually see it shown as % APR (annual percentage rate). What is APR?

There are different rates for different ways you can use your card.


  • Purchase rate: The interest you pay when you use your credit card to buy things. Companies will often offer 0% interest on purchases for a fixed amount of time
  • Balance transfer rate: When you move what you owe on one card to another. Many credit card companies offer 0% interest on balance transfers as a promotion to get you as a customer
  • Cash transaction rate: When you use your credit card to take money out of a cash machine or get cashback at a till. You are charged interest from the day you took the money out. We don’t recommend ever using your credit card to withdraw money

You can usually avoid paying interest on a credit card if you pay back the total amount you owe each month. Cash transactions will always charge interest.

Read our guide to paying off credit card debt.

Overdrafts are a very expensive way to borrow money.

If you use your overdraft a lot, it might be a good idea to look into other options which don’t charge as much interest.

There are two types of overdraft you can get on a standard current account:


  • Arranged: An amount of money the bank agrees to lend you when your account does not have enough money in it
  • Unarranged: When you spend more money than what you have in your bank account, without an agreement with your bank to do this

You will need to pay the money back into your account for both types of overdraft. And may also have to pay interest.

You will usually see interest rates for overdrafts shown as % EAR (equivalent annual rate). What is EAR?

Banks will charge up to 40% EAR when you spend more than what you have in your account.

How much interest you will pay depends on what type of bank account you have, how many days you are overdrawn, and if you regularly pay off your overdraft or not.

Arranged overdrafts

These sometimes have an agreed amount of money you pay no interest for. For example, the first £50 of your overdraft. So you only pay interest if you borrow more than that amount. But this is not always the case.

Arranged overdraft example:


  • You use £100 of your overdraft for a month
  • Your bank charges you an interest rate of 40% EAR
  • You need to pay back a total of £102.87
  • That means you have paid £2.87 in interest to use your overdraft if you pay it off quickly

If you don’t regularly pay your overdraft off or payments don’t go through, your credit score could go down. This could make it difficult to borrow money in the future.

Unarranged overdrafts

These have higher interest rates for borrowing. Sometimes banks also charge extra fees for using an unarranged overdraft.

It can be a quick way to cover unexpected costs, but the impact on your credit score and finances is not worth it. And it could make it difficult to borrow money in the future.

Some banks give you until midnight on the day you go overdrawn to pay back the money into your account. Then they will not charge you interest for that day. This can help if you go overdrawn by accident.

Read our guide to dealing with overdraft debt

Loan interest rates are usually fixed. This means the interest rate will not change for the length of time the loan is for.

And it means the amount you pay back each month will stay the same too. But be aware that some loans do have variable interest rates.

It is important to check the terms carefully when you apply.

When you apply for a loan:


  • You choose how much you want to borrow
  • Then set how long you want to borrow the money for

The lender should show you:


  • The interest rate they are offering you
  • How much your monthly payments will be
  • How much you will pay back in total

The longer you borrow the money for, the more interest you will pay in total.

Always check if your lender is approved by the FCA (Financial Conduct Authority) before you take out a loan. You can check which lenders are approved on the Financial Services Register.

The interest you pay on a mortgage is a percentage of how much you owe. The two main types are fixed rate mortgages and variable rate mortgages.

Fixed rate mortgages mean your payments stay the same each month for as long as you have fixed it for. This is usually 3 or 5 years. You can then find another fixed rate deal to swap onto.

Variable rate mortgages mean your monthly payments can go up or down when interest rates change. You may see this type called ‘tracker mortgages’ or ‘standard variable rate mortgages’.

Read more about mortgage interest rates.

What charges you might see

Charges are costs added on top of the amount you borrow. It is different to interest but both can be added to what you owe.

The people you owe might charge for:


  • Account fees or maintenance fees - a cost each month to have the account
  • Foreign transaction fees - if you use your card in a different country
  • Balance transfer fee - to move money from one card to another
  • Cash withdrawals - to take out money at a cash machine
  • Late payment fees - for not paying the minimum amount each month
  • Early repayment fees - if you want to pay your loan or mortgage off before the end of the agreed term

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Credit jargon explained

Use the dropdown boxes to find clear definitions for words you might see in messages from the people you owe.

123

You will pay no interest for a set period of time.

When this period of time has finished, standard interest rates will then start to be charged on the money you still owe.

You will see this mentioned in credit card adverts, such as 0% interest, 0% purchases, 0% balance transfers.

A

Banks and credit companies use APR for products like loans and credit cards. APR is shown as a percentage.

This shows you how much it costs to borrow money over a year, including interest and fees. The lower the APR, the less it costs to borrow.

Banks use AER for savings and investment accounts. AER is shown as a percentage. The percentage shows you what you could earn in interest on top of your savings.

They usually work using compound interest, meaning you can earn interest on top of interest you have already earned.

Arrears is the name for the money owed from late or missed payments.

You can fall into arrears when you fall behind payments for things like mortgages, gas and electric bills, loans and child support.

B

This is the total amount of money owed. It includes any fees and interest charges. You will see it mentioned on things like credit card statements or in online accounts.

Balance can also mean the amount of money available in your bank account. This is often called your ‘account balance’.

This is when you move a balance from one card to another. People usually do this with a different provider to get a lower interest rate. There are often balance transfer fees.

Buy now pay later is a type of short-term loan used by many online shops. It lets you buy a product without paying the full cost upfront. Then you have to pay it later, or in smaller instalments. You may see it written as BNPL.

It can often cost more to use this kind of loan. People are not always aware it is a credit agreement that can affect your credit score if you miss even one payment.

C

This is the amount you agree to pay the lender each month. It is agreed when you sign your contract.

Credit makes it possible to borrow money and pay it back over time. Credit usually comes with added interest to pay for borrowing it.

There are lots of different types of credit. Such as loans, credit cards, mortgages, car finance and overdrafts.

This is a legal contract between you and the lender. It explains what terms you are agreeing to.

A credit file or ‘credit history’ is a report showing your financial history. You might also see it written as a ‘credit report’. Lenders will use this information to check if it is responsible of them to lend to you.

A credit file is not the same as a credit score.

The most you can spend on a credit card.

Organisations that record your credit history. When you apply for credit, a credit reference agency sends your credit file to the lender. The lenders then use it to decide if it is responsible of them to lend to you.

A credit score is number that ‘scores’ your history of using credit. It is one of the ways lenders work out how much risk there is in lending to you. A higher number means a better credit score.

Each lender will use credit scores in different ways. But the better your credit score, the more options may be available to you.

This is when a lender looks at your credit history. It can also be known as a credit check. They do this when you apply for credit.

This is the person or company you borrow money from. Also known as a lender.

D

Debt is when you owe money to a lender.

This is the person who owes money and has to repay the debt.

A default is when you break the terms of your agreement. It usually happens when you miss payments.

It shows on your credit file for six years. This could make it more difficult to take out credit during this time.

A type of automatic payment. You give permission for a company to take payments from your bank account on the same date every month.

E

This is the interest rate used for overdrafts. EAR is shown as a percentage.

The percentage shows the amount of interest you would pay if you were in your overdraft for a year.

It is worked out by looking at the interest rate and how many times it will be charged in a year. The higher the percentage, the more expensive it is to use your overdraft.

F

The UK's financial regulator. They make sure that finance companies and lenders treat customers fairly.

A UK service that deals with complaints between customers and finance businesses.

G

This is another way of saying the total amount. You might see ‘gross interest’ mentioned on statements. This is the total interest owed.

A guarantor is someone who agrees to pay your debt if you do not.

L

Extra charges that lenders add if you do not pay on time.

Something you are legally responsible for.

M

The smallest amount you are allowed to pay towards a debt.

O

The amount of money you have left to pay on a debt.

Extra charges your bank adds when you use your overdraft.

P

Persistent debt is when you have been paying more in interest and charges than towards what you owe for 18 months or more.

It happens when you are only making small repayments each month. Such as only making the minimum payment each month.

This means it will take you a long time to pay back what you owe in full. And it will cost you a lot in interest and charges.

Priority debts are debts that can lead to serious problems if you miss payments. Such as your home being repossessed or being sent to prison.

Priority debts include:


  • Court fines
  • Council tax
  • Your rent or mortgage
  • And more

They become ‘priority arrears’ if you miss payments.

This means a lender approves you to take out credit before you apply. You see offers like this when checking your credit score.

S

A UK law that protects you if something goes wrong with your purchase or lender. It applies to purchases between £100 and £30,000.

A secured loan is when you link a loan to an item of value that you own, like your house or car. You could lose the item if you do not pay back what you owe.

If you secure a loan on your house, it could be repossessed if you don’t keep up with your loan payments.

T

An amount of time.

If the term of a loan is 12 months, you pay that loan back over 12 months.

U

An unsecured loan is not linked to items of value, like your home or car.

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