The funds borrowed allow you to achieve your goals at the present moment. But the ability to use a certain amount of money before you have earned it comes at a price. The interest rate is a major, but not the only element in forming the “price” of the credit. There are also other costs that are taken into account – taxes, commissions, insurance, etc. It is important to be aware of both the main elements that form the final price of the credit and the factors that influence its determination under a given offer. Awareness of these issues will help you adequately assess the parameters of credit offers and make a choice suitable for your personal circumstances.

 

Interest and Interest Rate

In everyday life, the terms “interest” and “interest rate” are often used interchangeably, although there is a difference in the meaning.

The interest is the specific amount that the borrower pays to the lender as a price for the use of the granted amount, called the "principal". The interest is calculated as part of the principal and is paid according to the agreed terms.

The interest rate serves as a measure and indicator of the cost of the loan. It can be fixed or variable/floating.

The fixed interest rate is determined in the loan agreement and is subject to change for the term for which it is agreed. It can be applicable for the entire term or only for part of it, which is the usual practice for long-term loans. For example, you have a 20-year mortgage, where the interest rate is fixed for the first 3 years, and then it switches to floating.

The floating interest rate is formed by two components, according to the Bulgarian legislation:

- Reference interest rate (RIR): A variable component that follows market dynamics. It may be based on an index and/or indicator of the Bulgarian National Bank (BNB) or the National Statistical Institute (NSI). For example, for loans in euros, the reference interest rate EURIBOR is usually used. The methodology for calculating it is described in the loan agreement and cannot be changed unilaterally. Credit institutions are obliged to inform their clients about upcoming changes to the RIR, because they affect the interest rate and, accordingly, the amount of loan installments.

- Fixed surcharge: Its amount is agreed and remains constant for the entire term of the loan. The surcharge expresses the risk that the bank takes when granting a loan to a specific consumer. A number of factors are taken into account when determining it - the creditworthiness of the recipient, the availability of collateral for the loan, guarantors, etc. Thus, if you have a good credit history, the bank may offer you a fixed surcharge at a lower rate compared to its other clients, i.e. you will be able to use a loan under more favorable conditions.

 

Annual Percentage Rate of Charge

Indeed, the interest due on the principal forms the main cost of the loan, but in addition to it, there are other costs that must be taken into account. The Annual Percentage Rate of Charge (APR) is the indicator that expresses the total cost of the loan in the form of an annual percentage. The APR shows how much the loan will cost you per year, including not only the interest, but also all additional costs (fees, commissions, costs of preparing the contract and maintaining the account, mandatory insurance). Its calculation is based on a unified methodology and is regulated in the Consumer Credit Act (CCA) and the Consumer Credits Related to Immovable Property Act (CCRIPA).

The APR is the most accurate indicator for comparing different loan offers. The lower its value, the lower the total costs of the loan, i.e. its "price". It is possible that the interest rate on a given offer is advantageous, but the APR is higher compared to another. For example, one has a 7% interest rate and an 8% APR, and the other has a 7.3% interest rate and an APR of 7.8%. This means that even if an offer seems to have a lower interest rate, it may end up being more expensive due to additional costs. This is why it is important to look at the APR, not just the interest rate.

 

The effect of compound interest on loans

In the world of investments, we accumulate wealth through the mechanism of compound interest. The same effect, but with the opposite sign, is valid in the world of lending. This means that with investments, compound interest works in our favor and our money grows over time. However, with loans, this effect works against us - the longer the term of the loan and the higher the interest, the more we will pay in total.

The amount of the interest rate determines the speed of debt accumulation - even a small difference can have a significant impact in the long term. For example, if you have a 20-year mortgage loan for 100,000 EUR, with an APR of 5%, lowering it by just one point to 4% will reduce the total amount owed from about 157,000 EUR to about 145,000 EUR. Therefore, it is a good idea to seek to achieve the lowest interest rate possible, including by refinancing an existing loan.

While interest rates are often beyond our control, the term of the loan largely depends on our individual financial strategy and capabilities. A longer term can provide lower monthly payments, but leads to a higher total cost of the loan, and vice versa. If we return to the above example of the 100,000 EUR loan at a 5% APR, extending the term from 20 to 30 years would lead to a decrease in the monthly payment from about 650 EUR to 530 EUR and at the same time - to an increase in the total amount due from about 157,000 EUR to about 191,000 EUR. When considering the appropriate loan term, it is important to find the right balance for you between the budgetary convenience of a lower monthly payment and the economy of a lower total amount to be paid.

When the loan payments are annuities (fixed monthly payments that include both interest and principal), at the beginning of the loan the majority of each payment covers interest and over time the portion of the principal increases. If you choose a loan with a longer term, your monthly payment will be lower, but you will end up paying more interest because your debt will accrue over a longer period. For example, if you plan to repay it early, a longer term would be better for you, since the monthly payment will be lower. However, in the long run, a longer loan term will always result in a higher total amount of interest.

Choosing a loan is an important step that requires careful planning and cost evaluation. Understanding components such as interest rate, APR, and the effect of compound interest will help you make an informed decision that meets your financial needs and goals.

 

Useful links

Закон за потребителския кредит

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