Consumer loans are taken out to finance a daily necessity to a consumer good or commodity, such as furniture, a new kitchen, electronic devices, or even a holiday, for which there is not an available credit balance on a bank account or savings account. The term consumer lending also covered the possibility to have an overdraft facility on a bank account, credit card-based loans, as well as options provided to pay in instalments, such as in the retail sector.
Consumer lending offer a convenience and quick form of financing, but which also contains risks and costs which should not be overlooked.
Due to their increased risk of default, consumer loans are as a rule more expensive than other loans. On average, in 2017 annual interest of 5% was paid for consumer loans. In comparison: for housing loans, the average interest is 1.87%.
Many consumer loans also use variable interest rates, meaning that the interest rate may change across the term of the lending, in particular the interest rate may also increase and the repayment of the loan becomes more expensive!
In a loan agreement a debit or nominal interest rate is agreed, which is applied to the outstanding amount paid out of the loan. Where the capital is repaid on a constant basis, in the case of a repayment loan, the interest amounts therefore decrease constantly. This interest rate may be either fixed or variable.
On the other hand the effective annual interest rate also takes into account the total costs of the loan. It therefore contains, in addition to debit interest the fees, commissions, account management fees. Processing fees and the costs of insurance contracts where they are required to be concluded and the amounts involved are already known. Where the amount is not known, it is necessary to at least advice that there is a requirement to conclude such an insurance.
The effective annual interest rate therefore expresses the total costs of the loan as an annual percentage of the total amount of the loan. This allows loan offers to be compared with one another even where the loan amounts and terms are different.
Example about the Difference between Borrowing and Annual Effective Interest rates:
Even where the same borrowing rate applies, loans may have different effective annual rates, as banks also charge different fees in addition to the interest paid on borrowings.
FMA Focus on Consumer Credit