What you need to know about borrowing money

How interest works

Interest is essentially the cost of borrowing – the higher the rate and the longer you take to repay, the more it costs you overall. For example, if the interest rate on a product is 20%, then borrowing £100 now would mean paying back £120 after a year if you haven’t made any repayments.

As time passes, this interest will compound (meaning you pay interest on the interest), so after two years with no payments, that debt would rise again to £144.

In reality, most lenders will require a minimum monthly payment, and if you miss payments, you’ll typically face penalty charges on top of the interest already accruing. Missing payments can also damage your credit score and affect future borrowing. So it’s easy to see how quickly debt can grow without a plan to pay it back.

Types of borrowing: from mortgages to credit cards

The biggest debt most people incur in their lifetime is a mortgage. Mortgages are a way for people to buy a home without having to save up the full purchase price first. You pay a small percentage of the cost upfront (the deposit), with the rest lent to you by a bank (the mortgage). If you don’t make payments, the bank can force the sale of your home to recover their money.

This makes it a relatively secure investment for the bank, which is why annual interest rates on mortgages are much lower than for other types of borrowing. A mortgage can be a fantastic tool, allowing people to own their own home, but as with any financial decision, you need to think through the cost carefully. Interest rates can change and costs can rise, so you need to be sure that any borrowing would still be affordable if this were to happen.

Recommended reading: Getting your first mortgage: What I wish I’d known before starting the process

For other types of borrowing, interest rates are usually higher, reflecting the greater risk to the lender. Credit cards are a good example of more costly borrowing, where interest rates are often 20% or higher. Many credit cards and store cards also offer 0% introductory periods, but it’s important to know what rate kicks in when that period ends, as it can jump up significantly.

Smart money talks

Before borrowing any money, you need to be sure you can afford the repayments. This is where having open money conversations can really help. Talking to someone with more experience and someone you trust can help you understand whether borrowing is the right decision in your circumstances, and whether it is genuinely affordable.

Take credit card spending. Using a credit card isn’t wrong – if you keep on top of it and use it well it can help you build your credit history and score. You may even benefit from perks such as cashback or air miles! Unfortunately, many young people are given access to credit without the financial education they need. It can feel like an easy way to improve your lifestyle in the short term, but borrowing beyond your means can trap you in a cycle of unaffordable repayments.

Summary

Borrowing money can be a helpful tool to help you meet your financial goals, but it should always be done with caution and care. Ask questions to make sure you fully understand what you are committing to, and that it is genuinely affordable. If in doubt, don’t keep it to yourself – talk to people around you about their experiences of borrowing to help you weigh up the pros and cons.

This article is for information and education only. It does not constitute financial advice. If you’re unsure about a borrowing decision, consider speaking to a regulated financial adviser. If you’re finding debt or repayments difficult to manage, you don’t have to figure it out alone. Free, impartial debt advice is available through services like MoneyHelper and StepChange.