What are interest rates?

What are interest rates? It’s an important financial term to understand as it can have a big impact on your finances.

Whether we are saving money or borrowing it, the interest rate being applied to our account makes a difference in how quickly our savings balance grows or how expensive debt becomes.

Understanding interest and its influence on our money is important at all times, but it’s even more crucial during a cost of living crisis when everyone is having to work harder to get the most from their bank balance.

So what are interest rates and why should we worry about them?

What are interest rates?

How do interest rates work for savings?

Let’s start with the positive side of interest rates, and how they can help you build a bigger savings pot.

When you put your money into a savings account, one of the main features of that account that you’ll want to pay attention to is the interest rate. This is effectively what the savings provider is paying you by way of an incentive to keep your money with them. 

The higher the interest rate, the faster your savings balance will grow.

Different types of savings accounts will pay different interest rates. As a rule, you’ll get the smallest return from accounts that offer easy access, meaning you can get your hands on the money whenever you like. 

But, if you lock your money up for a period, such as a one-year bond, then you’ll get a higher interest rate. Generally, the longer you lock the money up, the higher the interest rate on offer.

The interest rate on offer may be variable. This means that the savings provider can increase or decrease it at any time. 

Other savings accounts offer a fixed rate of interest, meaning you know exactly what return you will get on your money for a specified period of time. A five-year fixed-rate bond for example will pay the same interest rate on your savings for five years.

The way that the interest is paid will also differ between accounts. Some will pay interest on a monthly basis, while others pay annually. The right account for you will depend on how often you want to receive those interest payments.

Savings interest rates and inflation

How the interest rate on your savings account compares with the rate of inflation is an important element to bear in mind. 

Inflation is the measurement of the rate at which prices are rising, and you want to have a savings account that pays at least that level ‒ otherwise, your money is effectively losing value in real terms, even if in cash terms your savings balance is going up.

Unfortunately, with inflation at such high levels currently, there are no savings accounts paying an interest rate that comes close.

How do interest rates work for debt?

If you have some form of debt, such as an overdraft, a credit card or a mortgage, then chances are your debt is subject to some form of interest. This is important, as it influences how long it will take you to clear that debt, as well as how much it will cost you overall to do so.

Let’s start with credit cards. If you pay your balance off in full each month, then you won’t pay any interest on the balance. That’s true of all cards, no matter whether they have an interest-free offer in place or not.

If you don’t pay the balance off, then you will be charged interest on the outstanding sum. That rate of interest will vary depending on your credit card, and could even vary based on how you have used your card. For example, the interest charged if you use your credit card to withdraw money from an ATM will often be higher than that charged on purchases.

The interest rate will therefore determine how much it costs you overall to clear that debt, and potentially how long it takes you in order to pay it off.

As with savings accounts, the interest rate on debt can be variable or fixed, depending on the product you’re using. 

Lots of different factors will play a part in determining the interest rate you are charged on your debt, with the risk being a big one. The riskier you seem to the lender, in terms of repaying that debt, the higher the interest rate will likely be. So if you have a history of missed or late payments, or you have a variable income, then you may find you are offered a higher interest rate than another borrower with a spotless record or a regular income.

What about the Bank of England’s bank base rate?

Most months the Monetary Policy Committee at the Bank of England will meet, to determine whether to change the bank base rate. It’s important to understand that this decision will not automatically have an impact on the interest rates which apply to your own finances.

For example, just because the Bank of England increases the base rate by 0.5%, that doesn’t mean that you will see a similar increase in the interest paid on your savings, or charged on your mortgage.

There are some exceptions to this, as certain products are directly tied to the base rate. A tracker mortgage for example, as the name suggests, tracks the base rate, usually charging a couple of percentage points on top. So if your mortgage comes with a rate of base rate plus 2%, and the Bank of England increases the base rate from 3.5% to 4%, then your mortgage rate will move from 5.5% to 6%, and your monthly repayments will increase in line with that. 

But, if you are in the middle of a fixed rate term on your mortgage ‒ say, in the second year of a five-year fixed rate ‒ then your interest rate and repayments will not change until the end of your fixed term, irrespective of what happens with the base rate.

So why is base rate important? Essentially, it’s the rate paid by the Bank of England to banks who hold money with it. As a result, it will have a knock-on impact on the rates that those banks pay their savers or charge their borrowers, but there will be other factors which also impact those rates on offer.

What is APR?

APR stands for the annual percentage rate and is often used when referring to the interest charged on your borrowing.

In simple terms, it is the rate of interest that you’ll pay on your debt over a year. 

If you are researching credit cards, then you will see a ‘representative APR’ advertised. This is the rate which the credit card provider promises to offer to at least 51% of successful applicants. Crucially, if you fall into the other 49% ‒ perhaps because you have the odd black mark in your credit history, or you have a more complicated income setup, then you may be offered a higher rate of interest.

There is no obvious ‘good’ APR, however the lower it is, the less expensive the borrowing will be. APR is useful as a way of comparing rival products so that you can work out the right deal for you.

What is AER?

AER stands for annual equivalent rate and works much like APR, except that it is used when referring to the interest paid on your savings balance.

It demonstrates the rate you will earn on your savings over a year and can be used to compare savings accounts.

What is compound interest?

Compound interest can be a powerful ally or a significant danger to your financial health, depending on whether you are saving or borrowing money.

With savings, it is a good thing. Let’s say that you have £100 in your savings account, and a year down the line you earn 5% interest, taking the balance to £105. If you earn 5% interest in the second year, then you will get it on the full £105, meaning you end up with £110.25. That process of earning interest on previous interest is called compound interest, and it can help you build your savings pot to snowball in size.

However, the reverse is true when it comes to borrowing. If you borrow £100, and are charged 5% interest, then you will owe £105. Fail to pay it off, and you will then be charged interest on that full sum, meaning the size of your debt can snowball too.