Credit typically comes at a cost. When we borrow a loan or use a credit card, we incur an additional cost of borrowing which we repay along with our monthly instalments. This cost of borrowing is the interest that we are charged on credit.
This interest can vary from one lender to another and usually depends on your ongoing financial circumstances and credit history. The average interest that you can incur on loans ranges from 5-35%. But what if there was a way to avoid this additional cost?
Interest-free loans are a common phenomenon these days. Read on to learn more about the concept. Are they similar to 0% interest credit cards? Find out here!
What is interest on a loan?
The interest rate charged on a loan is fundamentally the cost of borrowing money, expressed as an annual percentage of the loan amount. Whenever we borrow credit, we repay the principal plus the interest charged on the loan, usually through fixed monthly instalments.
For instance, if you borrow an amount of £5000 at an annual interest rate of 8% for a year, you will effectively owe £5400; where £5000 is the principal and £400 is the interest on the loan (8% of 5000).
The total duration could be vary depending on the length of the repayment period – the longer you have a balance on your loan, the longer you’ll have to pay interest on it.
How does interest work?
Whenever you borrow a loan, the lender assesses your credit history and financial circumstances to determine the correct interest rate for you. This cost can be calculated as an annual percentage of the borrower amount. You then repay the money along with interest via fixed monthly instalments.
Apart from your credit profile and financial standing, a critical factor that influences changes in interest is the base rate set by the Bank of England. The BoE base rate currently stands at 0.1%, which is the lowest it’s ever been in the bank’s 326-year-old heritage.
The BoE base rate is the basis for the interest rates set by financial institutions. If there’s an increment in this rate, the interest rates will most likely go up as well. Conversely, if this rate plummets, then the interest rates will likely go down.
What are interest-free loans?
When they hear ‘interest-free’, the first thing that would pop up in peoples’ minds is a credit card. Most credit cards offer promotional periods of 0% interest that sometimes last for up to 2 years. Not a lot of us would think of interest-free loans of the top of our heads.
Interest-free loans undoubtedly sound like an enticing proposition for borrowers. Conceptually, these loans completely justify their straightforward terminology – they’re loans without interest. Interestingly, these loans may not be entirely free either.
Lenders advertise these loans as seemingly ‘interest-free’ but still get you to pay a fee in some or other way. There are three main ways for them to accomplish this:
- Promotional offers: Lenders and credit card providers offer 0% interest over a promotional period of 1-2 years. As soon as this period expires, you will have to repay the credit at a standard interest rate higher than conventional loans. In such cases, the loan technically is ‘free’ but only over a limited period. This practice can be seen in 0% interest credit cards wherein you need not pay interest on credit for typically 1-2 years.
- Interest deferral: Interest deferral essentially involves deferring interest payments until the end of a promotional period offered by creditors. However, you won’t have to pay interest if you manage to pay off the entire loan within the promotional period. If you fail to settle your arrears before the end of the deferral period, you might have to pay retroactive interest payments on the credit.
- Additional charges: The third way for lenders to wheedle out money from you is by offering an interest-free loan, but with additional charges. These charges include – early repayment charge, loan origination fee, missed payment charges or application fee. How lenders usually go about this is by deducting the additional charges from your loan amount. Assuming that you only borrow the amount you need, you might have to borrow extra to compensate for the deduction. These additional charges are often hidden in the ‘fine print’ shadows and are, thus, overlooked. It would be best to review the document scrupulously.
Can I borrow an interest-free loan?
Most people opt for interest-free loans to cover big-budget expenses. Some of these expenses include:
- Purchase of high-cost goods: Various stores that deal in a range of expensive products (electronic appliances, jewellery, furnishing, etc.) might offer interest-free loans and 0% interest credit cards. Such stores primarily offer BNPL-like (Buy Now Pay Later) interest-free loans with deferred interest. You can avoid paying interest by clearing your loan within the 0% promotional period. If you fail to keep up, you might have to retroactive interest arrears on loan.
- Purchase of a vehicle: Most automobile companies roll out upgraded car models in the last two quarters of the year. Car dealerships often use interest-free loans mid-year to clear out existing car models to make room for the upcoming ones. These loans make it way more comfortable for people to afford their purchases.
- Expensive medical procedures: Numerous dental and cosmetic procedures could break your bank if you decide to pay in a lump sum. Doctors and dentists commonly offer interest-free loans to people to help them cover these costs. Since these procedures may be elective, insurance may not cover the expenses.
What to consider before borrowing an interest-free loan?
An interest-free loan may sound like the ideal credit solution, but there are several implications associated with it. Here are some questions you should reflect upon before considering an interest-free loan:
- Do you completely comprehend the loan’s working?
- Will you be able to meet the eligibility criteria for interest-free credit?
- Will you be able to clear off the balance before the end of the interest-free window?
- Are there any financial constraints that you are overlooking?
- Can this purchase wait until you’ve saved up enough funds?
- And, will you be able to curb the temptations of overusing the 0% interest credit card?
Contemplating these areas might help you make a better borrowing decision. It would be best to factor in the pros and cons of interest-free loans as well:
- Save on interest: If used responsibly, an interest-free loan allows you to save on interest. But remember to settle the loan within the promotional period, or you could end up paying more than you bargained for.
- Expedite your purchasing ability: Sometimes, it isn’t easy to hold off a necessary purchase until you’ve saved up enough cash. For instance, you wouldn’t want to wait to save up to buy a boiler during the winter months. An interest-free loan is a great way to afford expensive purchases without breaking your bank, provided you repay it within the 0% interest window.
- Stricter eligibility checklist: You may need a good credit score (670 or above) to avail of an interest-free loan.
- Limited to specific purchases: In most cases, interest-free loans are limited to purchasing expensive goods and services.
- May not be entirely free: There’s always a catch in flashy advertisements and unrealistic offers. In this case, too, lenders and creditors implement numerous tactics to get you to pay up.
Interest-free loans can be instrumental in easing your financial burden, especially when you’re planning to make a big-ticket purchase. But it is vital to understand how the product works before opting for such credit. Advertisements can easily colour your opinion, so consider the pros and cons before borrowing this loan.