Interest rates — do you really understand how they work and more importantly the effect they can have on your financial well-being? Most aspects of financial advice involve numbers and rates of interest either for repayment of a loan or the growth on an investment. Lots of different numbers are quoted, often to make the cost look more attractive or the return to look better. If you know what you are looking at, hopefully this can lead you to making a more informed decision about your financial affairs and so avoid any nasty surprises.
Starting with borrowing, there are two main types of loans — secured or unsecured. Secured loans are, as the name suggests, attached to an asset, such as a property, or here in the UAE, a car. The second type of loan is an unsecured, which has no collateral or asset attached to it — you are simply lent the money. The main difference between the two is that with the security of an asset, the lender is willing to loan the money at a lower interest rate, as the risk of losing the money is lower. However, especially in the case of a property purchase, the term of the loan is much longer, so the interest is paid for a longer period of time.
There are a number of ways to show the rate of interest. Starting with savings, which is generally (although not always) more straight forward. The return is simply the amount of growth the investment has achieved over a set period of time, normally displayed as 1, 3, 5 or even 10 years. This can lead to some large numbers being shown, but obviously if they are then divided by the term, a more sensible figure can be seen. The dates used for the figures can also give different results to the actual returns seen by investors. Often calendar years are displayed, but even being a few days either side of this can give very different returns. These are also illustrating past performance, not expected future returns, and so give no guarantee of what the investment may deliver going forwards.
Moving on to loans, in my experience, this is the area that can generate the most confusion. Loans are often shown with the Flat interest rate, which is based on the amount of money a borrower receives at the beginning of a loan. However, if repayment is scheduled to occur at regular intervals throughout the term, the average amount to which the borrower has access is lower and so the effective or true rate of interest is higher. A more representative figure is the Annual Percentage Rate. This is the annual rate that is charged for borrowing expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This also includes any fees or additional costs associated with the transaction, so gives a far more representative cost of the borrowing.
Another point to be aware of is the period of time that the interest is being charged over — on occasion the interest displayed is the monthly not annual interest — again this can have a huge effect on the actual cost of borrowing.
This is just a brief overview of the different terms and types of interest rates being quoted, but I hope that they give some insight into an important subject matter. Before entering into any loan, ask yourself whether you really need to borrow the money, as this will be the cheapest way to avoid the cost of borrowing, but if you do ask lots of questions and be sure that you understand what the terms of the loan really are.
— James Thomas is Regional Director at Acuma Independent Financial Advice
