What are interest-free loans?

If you’re in the market for a short-term loan, you probably know that borrowing money doesn’t come for free. Lenders must make some money from the practice of lending. This often comes in the form of interest charges that are applied, usually as a percentage of the outstanding loan amount.

So why are some lenders suddenly offering what seem to be 0 interest loans or no-interest loans? Can these really be interest-free loans? What’s the catch?

Here, we take a look into the world of 0 interest loans to get to the bottom of what this term means and whether there are any ways to borrow money for free. So, if you’ve got questions such as ‘how does interest work on a loan?’ ‘What does 0 finance mean?’ And ‘is there such thing as small interest-free loans?’ We’ve got you covered.

What is interest?

Before we start exploring interest-free loans, it’s important to establish exactly what interest is.

Interest is a charge applied to a loan, usually calculated as a percentage of the loan amount, and paid by the borrower each time they make a repayment on their loan.

These charges are the lender’s payment for their services. Interest also allows lenders to align their fees with the term and the value of each loan and also spreads the cost of borrowing over the term of the loan. So borrowers who repay faster will often pay less in interest than those who borrow for longer.

It’s worth noting that, as well as interest payments, as a borrower, you may incur other costs. For example, if you are late making a scheduled repayment, or paying your interest, you may be charged an additional fee in the form of a penalty. Then there are charges for things like setting up loans, repaying early or borrowing more. Needless to say, checking the small print on a loan before signing on the dotted line is essential, so you know what you're in for.

What is APR?

Well, APR (or Annual Percentage Rate) refers to the complete cost of your borrowing for a year. APR includes any fees and interest you’ll be required to pay (so the total cost of your loan). Put simply, the APR is a broader measure of the price of your loan.

For more insights on fees and costs, head over to our how-to calculate the cost of a loan guide.

Do 0-interest loans, or interest-free loans exist?

Some lenders will charge no interest on their loans, but they have to make money some other way. For example, there are a few lenders out there right now who will offer some limited access to interest-free loans to ‘members’ who pay a monthly fee for their membership. These monthly fees are often a set amount and there are strict limits on the value and frequency of borrowing by ‘members’.

Although these lenders can advertise as charging 0% interest on their loans, the loans themselves are still costing borrowers money, they are just being charged differently.

Some of the lenders working on this membership model, promote their products as helping borrowers to boost their credit rating.

What’s a credit rating?

Your credit ratings are the scores assigned to you by credit rating agencies. The scores help creditors decide how much risk is involved with lending to you. A credit score is based on your credit report and credit history, which shows how much credit you have taken out in recent years and how reliably you repay.

Your credit rating can be viewed as a judgment of your creditworthiness. A higher score signifies someone who is judged to be highly creditworthy, while a lower score indicates poor creditworthiness, which means lenders are likely to reject your applications for credit or charge you higher interest rates and limit your credit terms.

Can taking out credit help to improve your credit rating?

Companies that assess credit history and assign credit scores to consumers will find it difficult to do so if you’ve never had any credit. So yes, having some credit can help you to increase your credit score. However, taking on credit to boost your score is only advisable if you are certain you will be able to make the repayments on time, every time. If you pay late or default on repayments, you will do a lot more damage.

There are several other things you can do to improve your credit score before taking on debt, such as the following:

• Make sure you are registered on the electoral roll at your current address. This acts as proof of address and will help your credit score.

• Use Open Banking to link your bank account to your Experian account through Experian Boost, which will allow the credit reference agency to check for other evidence of responsible financial behaviour, aside from simply servicing credit.

• Try not to use your overdraft too much. If you have access to an overdraft facility through your bank account, keep your utilisation low. If it’s below 30%, this may boost your credit score.

• Make sure you make regular repayments on time. For any credit that you do have, making your scheduled repayments bang on time will contribute to your credit score positively.

• Keeping up with any scheduled payments you have, even if you don’t regard the repayments as servicing credit, can contribute to a stronger credit score. For example, credit reference agencies may look at things like subscriptions and bill payments to help assess your creditworthiness.

Do interest-free loans in the UK offer a good deal?

Although the idea of a 0% interest loan may seem like an attractive proposition, it’s vital to remember that taking out a loan will usually cost you money. If you are paying a monthly membership or subscription to take out an interest-free loan, tot up how much you will spend on these fees over a year.

Compare the annual cost of membership or subscriptions (which you may have to continue to pay even when you do not have an outstanding loan with a lender), to the cost of a loan that charges interest. You may find that the cost of the fees over a year is higher than the cost of a loan that charges interest. So, always carefully consider your options before making a decision.

As well as taking monthly fees into account, consider whether a lender offering interest-free or 0-interest loans can offer you the loan amounts and terms you need. Also, consider their lending criteria, affordability checks, and whether they offer loans with low interest.

Quick look - what to look for when considering 0-interest loans

• Total cost of monthly membership/subscription charges

• Any extra arrangement/joining fees

• Penalties for missed payments/ repaying early

• How many loans you can take

• How much you can borrow

• How long do you have to repay?

• What’s their reputation?

• Are you eligible?
  

Is there such a thing as interest-free credit?

So, if so-called 0% interest loans still cost the borrower money, is there any way of borrowing money for free? Well, providing you have a good credit rating, there are ways to access credit that don’t entail paying interest. Here are some examples:

Credit cards

If you use a credit card for purchases and repay the entire balance each month, you won’t be charged interest. This means you have access to short-term credit for free. However, as soon as you build up any kind of outstanding balance by not paying off your entire balance each month, you will start to incur interest charges.

Additionally, there are credit card deals that offer 0% interest on purchases or balance transfers for a set period. If used correctly, these cards can offer free access to credit and may be a better alternative to no-interest loans. However, again, if you have an outstanding balance at the end of the interest-free period, you will start having to pay interest, usually at a relatively high rate. So, it’s important to stay organised and keep on top of your finances.

Overdrafts

Overdrafts are another form of credit that, when handled right, can sometimes offer limited borrowing without paying interest. An overdraft is a line of credit up to a pre-arranged limit, usually offered by a current account provider.

Some bank account providers will offer limited overdrafts, of a few hundred pounds, for example, which are free providing they are repaid and that the borrowers don’t exceed the interest-free amount. Once you go over the interest-free limit, interest will start to be applied.

Interest-free credit on purchases

Some retailers will offer interest-free credit for large purchases, such as sofas, beds and electronics. As with any interest-free credit deal, borrowers will usually have to have a strong credit rating and credit history to be accepted. Lending on an interest-free basis to people with poor credit histories is seen as too high-risk for lenders.

The takeaways on interest-free short-term loans

Lenders need to make money on the credit they provide. As a result, credit will almost always cost you something. If you want access to quick, hassle-free cash that’s repayable in instalments over a flexible term and doesn’t cost the Earth, a short-term lender like Moneyboat could be a good option. We don’t try to pull the wool over your eyes when it comes to the cost of your loan. We’re upfront about our interest rates (0.79% per day) and we don't charge fees for early repayment. So, if you’re interested, head over to our guide on everything you need to know about payday loan criteria.