How do fees and interest rates work when financing a loan?

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Whether you are looking to take out a new personal loan, refinance existing debt, or have a business idea that needs funding, there are numerous issues to consider. All of the information you require is readily available from potential lenders. In addition, as a consequence of enhanced consumer protection brought in over recent years, the relationship between fees and interest rates is transparent. However, while the information is readily available, it is crucial that you fully appreciate how fees and interest rates work when financing a loan.

Factors to consider when taking out finance

When looking to secure a loan, there are four main factors to take into consideration which are:-

• Interest rate
• Duration of loan
• Fees
• Loan amount

The relationship between these four factors is significant and will depend upon your financial situation and requirements. For example, a short-term relatively high-interest rate loan may look “expensive” compared to longer-term lower interest rate finance. However, over the period of the loan, you may well pay more interest on the lower rate.

Your financial situation

Before we delve deeper into the relationship between fees and interest rates, it is essential to note that the headline rates and charges will be indicative of your financial situation. As a responsible lender, we will only provide finance you can afford. There may be alternative options in certain circumstances, such as use of security and/or guarantors. These will be discussed in the initial review process.

While we provide all of the information required to assess the cost of finance made available, it is essential to understand the various components.

Understanding fees and interest rates

While the duration of your loan will play a significant role in the overall cost, it is vital to understand the relationship between fees and interest rates. We will now take a look at some of the terms you will come across, and what they mean.

Nominal interest rate

The nominal interest rate does not consider loan setup charges and ongoing fees or how interest is calculated. This is a basic indicator of the interest rate charged. In recent years this has been superseded by the comparison rate, sometimes referred to as the annual percentage rate (APR).

Example loan: One year $10,000 loan at 15% nominal interest rate
Interest: Charged annually
Interest: $1500
Total repaid: $11,500
Nominal interest rate: 15%

Comparison interest rate

The comparison interest rate considers setup charges and is seen as more reflective of the “real” cost of a loan. If we use the same example as above, with a setup fee, the calculations are as follows:-

Example loan: One year $10,000 loan at 15% nominal interest rate
Set-up charge: $500
Total loan: $10,500
Interest: Charged annually
Interest: $1575
Total repaid: $12,075
Comparison interest rate: 15.75%

When calculating the comparison interest rate, the nominal interest rate of 15% is charged on the initial loan plus the setup fee, $10,500. This is then calculated as a percentage of the initial $10,000 loan to arrive at the comparison interest rate of 15.75%. So, when looking at refinancing a loan, you need to look at the comparison interest rate.

Periodic interest rate

This is where it starts to become a little more complicated. We have calculated interest as one annual payment every 12 months in the above examples. In reality, lenders will calculate interest quarterly, monthly or even daily, at which point it will be added to your outstanding balance. This is where the periodic interest rate is very useful.

To calculate the periodic interest rate, we need to calculate the periodic rate. In the first example, we will calculate the quarterly periodic interest rate, which takes into account interest on interest. When calculating the figures, the comparison interest rate of 15.75% would be shown as a number which is 0.1575. This is divided by the number of interest rate periods per year (4 in this instance) and multiplied to the power four. Consequently, the calculation is as follows:-

Quarterly periodic interest rate

Periodic rate: 0.1575/4 = 0.039375 (3.9375% per quarter)
Periodic interest rate calculation: 1+0.039375 ^4 = 1.167049
Periodic interest rate: 16.7049%

So, a comparison interest rate of 15.75% equates to 16.7049% when taking into account interest on interest. The interest is calculated quarterly and added to the outstanding balance. Therefore when calculating interest on the next quarter, this will include a degree of interest on interest.

Monthly periodic interest rate

Periodic rate: 0.1575/12 = 0.013125 (1.3125% per month)
Periodic interest rate calculation: 1+0.013125 ^12 = 1.169382
Periodic interest rate: 16.9382%

Weekly periodic interest rate

Periodic rate: 0.1575/52 = 0.003029 (0.3029% per week)
Periodic interest rate calculation: 1+0.003029 ^52 = 1.170302
Periodic interest rate: 17.0302%

Daily periodic interest rate

Periodic rate: 0.1575/365 = 0.000432 (0.0432% per day)
Periodic interest rate calculation: 1+0.000432 ^365 = 1.170541
Periodic interest rate: 17.0541%

To summarise the impact of interest on interest, a 15.75% comparison rate increases when interest is charged:-

Quarterly: 16.7049%
Monthly: 16.9382%
Weekly: 17.0302%
Daily: 17.0541%

While these figures may seem pretty irrelevant on the surface, they can convert into a significant level of additional interest on relatively large long-term high-interest loans.

List of charges

Here at Alternate Finance, we publish a schedule of rates and fees so that everything is transparent and upfront. These include:-

Interest rate

Our rates currently range from 13.95% to 26.98% per annum, depending on your financial situation and loan amount. The interest rate on your loan is fixed for the entire term, which allows you to plan ahead.

Default interest rate

If you fall behind with your payments, an additional 10% default interest rate may be added, over and above the rate that usually applies to your loan.

Establishment fee

We charge an establishment fee towards the cost of assessing and processing an approved loan application. The sliding scale equates to $95 for loans up to $499, rising to $1090 for loans of $80,000 and above.

Registration fee

A registration fee will be charged where any security interest is registered against a loan.

Administration fee

This charge is included in monthly loan instalments.

Variation fee

Where the terms of an existing loan need to be adjusted, a variation fee will be charged.

Full prepayment fee

You may be charged an administration fee or a prepayment charge where a loan is repaid early.

Overdue account notices

Arrears letters, unpaid item letters and final warning letters relating to the management of your loans will incur fees.

Default interest charges

Where a loan continues to be in default, there may be additional charges such as arrears letters, default loading fee, monitoring fee and variation cost.

Agent calls

Where a physical visit to the client is required in the event of a default, there may be additional charges incurred.

Repossession

In the event of a default, we may need to undertake repossession action, which would incur additional costs.

Recovery

Where there are third-party costs regarding collection or enforcement action, there may be additional fees to take into account.

Finding the right loan for you

Here at Alternate Finance, we offer a broad range of loans, including debt consolidation, car loans, house deposits, asset finance, small-business loans, and more. Whatever type of loan you are considering, you must be aware of the relationship between fees, interest rates and monthly repayments. As a responsible lender, our fees and interest rates are listed on our website. There are also references to the various scenarios in which they may be charged. We also offer personalised advice and guidance relating to your specific scenario.

As we touched on above, it is essential to find a balance between affordability and loan duration. The natural pull is towards as short a loan duration as possible. Unfortunately, sometimes this can leave little in the way of headroom in the event of further financial issues. If you were to default on your loan, there would be additional charges, and you may see a short-term increase in the loan interest rate.

A change in your circumstances

Even with the best will in the world, your financial situation could potentially worsen before it improves. Consequently, you must advise us of any material change in your finances that may impact your ability to cover monthly repayments. Depending on the specific scenario, there may be alternatives such as refinancing your loan for a longer duration, adding collateral, or even introducing a guarantor.

Conclusion

As you can see from the calculations above, there are various factors to consider when reviewing the cost of finance. While many people are fully aware of the importance of the comparison rate and the loan duration, there is also the issue of interest on interest. This might seem minimal in the short term but it is more pronounced the longer the loan.

Positioned between the retail banks and the high-interest rate payday lenders, we offer competitive loan rates for those experiencing a degree of financial difficulty. The sooner you take action, the more options available and the higher the likelihood of arranging finance.

Mark Benson

Mark previously enjoyed 15 years as a stockbroker/financial adviser and still maintains a strong interest in all things financial. Over the years, he has written about subjects such as property finance, loans, pensions, insurance, stock market investments, tax planning and more. Mark believes it is essential to keep up with the latest financial regulations and adapt your finances accordingly, something he portrays in his financial articles.

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