How interest rates are calculated

Posted by Richard Catlin in Personal Finance on 14 June 2019 - Richard is Marketing Director at checkmyfile.

If you’ve ever applied for a form of credit, you may well have discovered to your cost that the advertised APR and the interest rate you’re offered if you are accepted can be very different things.

That’s because the type of credit you apply for, where you apply for it and what your Credit Rating is all make a big difference to how your personal interest rate is calculated and as a result, how much you end up paying in the long-term.

Representative APR

Where you see a loan, credit card or pretty much any other form of regulated credit advertised, the interest rate shown before you apply is what’s known as a representative figure.

This means that the lender is only required to offer this rate to 51% of applicants – it is free to offer the remainder a different rate altogether. Where credit cards are concerned, the length of any introductory offer can also vary from the headline rate.

In some cases, possible alternative products are disclosed before you apply, but in others, you won’t know what rate you might get until afterwards. For example, Halifax has a credit card with a headline offer of 0% on balance transfers for up to 29 months, 0% on purchases for 3 months and a representative 19.9% APR. The same product also advises that you ‘keep in mind’ you may be offered a card with 0% on balance transfers for 18 months, 0% on purchases for 9 months and a rate of 27.9% APR – quite a difference.

Generally speaking, lenders will reserve their ‘best’ deals for customers with better Credit Ratings, but other factors such as demographics and lender appetite at any given time will also affect what is offered. The most important determining factor though, is known as ‘rating for risk’ – more on that below.

Risk Based Pricing

Lending decisions often involve more than a simple ‘yes’ or ‘no’, and that is where risk-based pricing comes into play.

The key consideration for any lender is to determine the likelihood of a borrower defaulting on repayments. The Creditworthiness and Affordability of each applicant are the two main factors in working this out and enable the lender to decide if it wants to have the individual as a customer at all, and if it does, what interest rate is applicable.

By adjusting the interest rate that borrowers pay according to how ‘risky’ they are deemed to be, a lender can effectively give itself a bit more cover against the proportion of customers that will miss payments or default on their credit agreement. Those that are deemed to be a lower risk are rewarded with a lower APR.

Your Credit Report plays such a big part in determining your creditworthiness because the way you have managed credit agreements in the past is seen as a very strong indicator as to how you will manage them in the future.

Each lender has its own scorecard that is used to determine the cut-off point and will set the starting point for interest rates (and adjustments to the typical rate) accordingly.

The only way to know where you stand is to check the information for yourself. Uniquely, checkmyfile allows you to check and compare the data being reported by all four of the UK's Credit Reference Agencies together in the same easy-to-understand format. It’s free for 30 days, and then £14.99 a month thereafter – you can cancel online at any time, or via phone or email.

Base rates

Interest rates themselves are often made up of different component parts. The Bank of England sets a base rate (unsurprisingly called the Bank of England Base Rate), which lays the foundations for most interest rates offered by banks for their finance products (in both lending and borrowing).

The degree to which base rate will affect your mortgage rate will depend to a large extent on which type of product you have.

Both variable and fixed rate mortgages will be influenced by the base rate at the point they are issued, but the big difference is that the former will change if the base rate does, whilst the latter will stay where it is until the end of the fixed term.

With the current level of uncertainty around the wider economy, many people are choosing to take the safer route of fixing their rate for a certain period. When any product term comes to an end, it’s likely that you will be move to the lenders' standard variable rate SVR) – which is likely to cost a lot more. To ensure you don’t pay more than you need to, that’s the time to remortgage. Again, bear in mind that your Credit Rating could play a big part in your ability to switch to a cheaper rate, so it’s vital that you stay on top of it.

Interest rates set by brokers

In addition to calculations already described, there are circumstances where a credit broker could increase the overall cost of borrowing further by adding its own fees, or inflating the amount charged to you in order to secure a bigger commission.

The new car market these days is underpinned by cheap finance offers, with the majority of deals still arranged via the dealer. While it has been long-understood that some of the interest rates offered by car dealerships might not be the most competitive when compared to personal loans offered by banks, a recent investigation by the Financial Conduct Authority highlights that some dealers increase the amount of interest charged to customers to inflate the amount they will make on commission.

Because some finance products offered by dealerships will involve ‘pricing for risk’ in the first place, any additional inflation of the cost is the last thing that is needed – hence the FCA attempting to crack down on dodgy practices.

It's worth remembering that applying for car finance at the dealership – whilst convenient – won’t improve your chances of being accepted. You are free to shop around for your own form of finance, and could save a lot of money based on the difference between the cheapest personal loan and the rate quoted by the dealership. The flip side of that is that you can sometimes secure a better deal by taking finance, but it’s important to keep your options open.

Promotional offers & fixed rates

When making a big purchase other than a car – on expensive electrical good or furniture for example, you’ll often find the retailer offering low or even 0% interest rates to try and tempt you into buying.

In these circumstances, pricing for risk doesn’t really make much sense and so it will largely come down to whether or not your Credit Rating is good enough to be accepted. The retailer will more often than not use a third-party finance provider, with the application processed at the till.

If anything crops up during the Credit Check that causes it to be declined, it can be a potentially embarrassing trudge back to the car with your purchases left behind.

How your Credit Report is used

Regardless of what you apply for, or where, your Credit Report will play a major role in the outcome.

In some cases it will simply help determine whether your application is accepted or rejected, but in others it could also play a big part in deciding what rate of interest you are asked to pay. The difference in the overall cost of credit could be considerable.

As well as up to six years’ of information showing how you have managed existing credit agreements, your Credit Report will also show your presence on the Electoral Roll, any Court information being reported, other people you are financially linked to and much more besides.

To see what lenders see when you apply for credit, you can try checkmyfile FREE for 30 days, then for just £14.99 a month, which you can cancel at any time.

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