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’I borrowed £500 to buy a computer and ended up paying £88,000!’

One woman’s sad story began with borrowing £500 for a Christmas present from a ‘friend’. Then the lender demanded large repayments. When she couldn’t make these, he charged her and added it to her debt. This spiralled until by the time she went to the police she had paid £88,000 back for her £500 loan.

To avoid getting yourself into trouble like this, it’s really useful to understand interest – the extra money borrowers pay to lenders in return for using the money. That way you can choose for yourself what to do based on the figures.

Starting simple

The simplest way of calculating interest – helpfullyHand with money called ‘simple interest’ – is to multiply the interest rate by the original borrowed amount each time. It’s rarely used in business, but your mum might agree to pay you it, and it’s easy to work out.

Say you want to borrow £100 to buy your family’s Christmas presents. You agree a 6% interest rate with your mum – but once you’ve got the money, you put off paying it back. Next year, you owe her £106. The year after that, another £6 is added so you owe £112. Until you pay the money back, you owe your mum an extra £6 a year.

Compounding the issue

More common in business is compound interest. At the end of each period interest is recalculated on the amount of money outstanding at this time.

Your mum’s got a bit fed up with you not paying back the money you borrowed, so you use a credit card next Christmas. You put £100 on plastic – where it racks up 14% compound interest each year.

Year 0 – you spend your £100
Year 1 – you owe an extra 14%, making your debt £114
Year 2 – you owe an extra 14% of the £114, making your debt £129.96
Year 3 – you owe an extra 14% of that, taking your debt to £148.15

You can see that after only three years your debt has gone up by 50%. This doesn’t depend on the loan period. In fact, the more often the interest is calculated, the more you have to pay. Some loan sharks can charge 100% interest weekly!

SharkBlood in the water

If the interest rate is very high you can end up working very hard to just pay off the interest each month, without ever denting the initial sum you borrowed. This is a loan shark’s dream. They find someone desperate and charge them outrageous interest – sometimes over 2000%. If the borrower can’t pay, they may threaten violence or blackmail. Stay out of their jaws!

Although you’re not eligible for credit cards or bank loans yet, you may get advances from work or loans from parents. Debt is a slippery slope, so good habits now will pay off later. Try to avoid borrowing unless it’s really necessary. If you do, paying it off should be a priority. If you find yourself borrowing more money to pay off existing debts, this is a bad sign – you may need help with your finances. Be savvy, be smart, and don’t get bitten.