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3 Debt costs

low of 0.5 per cent, combined with price inflation of 4.7 per cent, resulted in negative real
interest rates of minus 4.0 per cent (ONS, 2010b and 2010c). Unsurprisingly the low
interest rates offered on savings encouraged many households to reduce their debts –
particularly credit card debts – by running down savings balances.
Most mainstream lenders link interest rates, including mortgage rates, to the official rate of
interest, and so the cost of debt, including mortgage debt, declined over this period. This
is another reason why debt levels may have risen in the 1990s and until 2007. After 2007,
the relationship between the official rate of interest and the cost of debt products was
altered by a widening in the margin between them. Nevertheless, at the end of the 2000s
interest rates on mortgages and many other debt products were historically low.

3.3 More on interest

Let’s look at interest payments in more detail. We can return to the car loan I mentioned in
Section 3.1. If £10,000 is borrowed and no repayments of this principal sum are made
during the year, and the interest rate is 7 per cent p.a. with interest being paid once a year
at the end of the year, the interest charge for that year is £700. Thus, provided that the
principal sum owed to the lender remains at £10,000 and interest rates are 7 per cent p.a.,
the borrower will have to pay £700 each year to the lender.

Activity 4
How much would you pay in interest per annum if you make no repayments on a
principal sum of £50,000 and the rate of interest is as follows?

1. 5 per cent p.a.
2. 35 per cent p.a.
3. 7.5 per cent p.a.
4. 6.7 per cent p.a.

Answer
1.

2.

3.

4.

As you completed the calculations in Activity 4, you may have started to think of some
factors that could complicate the calculation of the interest charge. For example, what
would be the interest charge if some of the principal sum is repaid during the course of the
year In many cases, the answer is that the interest rate calculation will be based on the
average balance of the principal sum during the year. For instance, if £10,000 is owed at
the start of the year and £100 is repaid halfway through each month, then the outstanding

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