Understanding interest: The cost of borrowing and the growth of investments - M4Money Credit Union

Interest is essentially the cost of borrowing money or the return on lending money. When you borrow money from someone, such as a bank or a friend, they expect you to pay back the original amount you borrowed, known as the principal, along with an additional amount called interest.

Let’s say you want to borrow £1,000 from a bank for one year. The bank offers you an interest rate of 5% per year. This means that at the end of the year, you will owe the bank the original £1,000 plus an additional 5% of £1,000, which is £50. So, you will have to repay a total of £1,050 to the bank.

Interest can be calculated in different ways, depending on the terms of the loan. In this example, we used a simple interest calculation, where the interest is calculated only on the initial principal amount. However, there’s also compound interest, where the interest is calculated on both the principal and any previously accumulated interest. Compound interest can grow faster over time because you earn interest not only on the initial amount but also on the accumulated interest.

Let’s consider another example to illustrate compound interest. Imagine you deposit £1,000 in a savings account that pays an annual interest rate of 4%, compounded annually. At the end of the first year, you would earn £40 in interest, making your total balance £1,040. In the second year, you would earn 4% interest on the new balance of £1,040, which is £41.60. So, your balance after the second year would be £1,081.60. As you can see, with compound interest, your money grows faster over time.

It’s important to note that interest rates can vary depending on factors such as the loan term, creditworthiness, and prevailing market conditions. Lenders use interest rates as a way to mitigate the risk of lending money and to earn a profit. On the other hand, savers or investors can earn interest on their money by lending it to others or depositing it in interest-bearing accounts.

Why are credit unions able to charge lower interest rates?

Credit unions are often considered a go-to place for borrowing money because they often offer lower interest rates compared to traditional banks. This is primarily because credit unions are not-for-profit organisations that are owned by their members, rather than being profit-driven institutions.

Here are a few reasons why credit unions tend to have lower interest rates:

  1. Non-profit status: Credit unions are structured as non-profit organisations, which means their primary objective is to serve their members rather than maximise profits. This allows them to offer more competitive interest rates and fees.
  2. Member-focused approach: Since credit union members are also the owners, the interests of the members are prioritised. Credit unions strive to provide affordable financial services to their members, which includes offering lower interest rates on loans.
  3. Cooperative structure: Credit unions operate as cooperatives, where members pool their financial resources together. This collaborative approach allows credit unions to offer better interest rates as they have lower overhead costs and can pass on the savings to their members.
  4. Community-oriented: Credit unions often have a strong connection to their local communities and may have a better understanding of the needs and financial situations of their members. This can result in more personalised loan offerings and lower interest rates tailored to meet the specific needs of their members.

However, it’s important to note that interest rates can vary among credit unions, just as they can vary among different banks. The specific interest rate you receive from a credit union will still depend on factors such as your creditworthiness, the type of loan, and other individual considerations.

Overall, credit unions can be an attractive option for borrowers seeking lower interest rates, especially if you are eligible for membership and have a good relationship with a credit union in your community such as M for Money Credit Union. It’s always a good idea to compare rates and terms offered by different lenders, including credit unions, to find the best option for your borrowing needs.