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3 Debt costs

account for a large proportion of personal debt, it is easy to see why the UK economy can
be easily affected by even relatively small movements in interest rates.

Activity 5
Under what circumstances do you think it might be attractive to borrow at the following
types of interest rate?
1. Fixed rate of interest.

2. Variable rate of interest.
Comment
Assuming that borrowers have a choice and want to pay as little interest as possible,
choosing a variable rate may be preferred if interest rates are expected to fall, and
fixed rates may be preferred if rates are expected to rise. However, to assess which
would be cheaper requires a forecast of how rates will move during the life of the loan,
and making such forecasts is difficult because it is difficult to predict future rates of
inflation and interest rates. In addition, the choice may reflect the borrower’s
household budget. For example, households on a tight budget may choose a fixed rate
because this would provide certainty of monthly expenditure.

3.4 Annual Percentage Rate (APR)

You have seen that borrowers have to repay both the principal sum and interest to the
lender, and that the interest charge may be fixed, variable or capped. On top of this, there
are often extra costs. Some of these costs arise from fees which may have to be paid on
obtaining a loan and, under certain circumstances, on repaying the loan before the end of
the term. Such extra costs include:

1. Arrangement fees paid to the lender: These are usually flat rate, one-off fees and
are generally charged when the borrower takes out a fixed rate or capped rate loan,
or when remortgaging.
2. Intermediary fees: These may be paid when a borrower deals with a broker rather
than directly with a lender.
3. Early repayment (or ‘prepayment’) fees: These may have to be paid to a lender if a
loan is repaid early. The argument used by lenders is that earlier repayment can
incur additional costs. In the case of personal loans, early repayment charges mean
the lender gets a share of the interest which would have been paid had a borrower
kept the loan for the full term.
4. Tied insurance: Taking out insurance (for instance, payment protection insurance,
life insurance, home insurance) may be required with a loan. In other cases,
insurance may be optional, although this is not always made clear to borrowers, who
might end up paying for inappropriate policies. The commissions earned on such
sales add to the profits made on lending.

Given all these different potential charges, and the different methods of calculating
interest, it’s important to have a good means of comparing the total cost of debt on
different debt products. Fortunately, in the UK there is a way of ensuring an accurate ‘like

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