Interest rates explained without the jargon
Interest rates, what you need to know
Taking out a loan or opening a savings account can be complex enough without adding in interest rates. So let’s demystify them and explain how interest rates work, and what different interest rates mean, without the jargon.
First, a definition. Interest is the cost of borrowing money. That’s the case whether you’re the one doing the borrowing or the lending. We’ll explain that in a bit.
When we say that interest is the cost of borrowing money, what we mean is that in order for someone or someplace (like a bank) to want to lend their money, they’ll need to make a profit. The interest is their profit.
For example, if you borrow £10,000 from the bank to buy a used car, they might give it to you with an annual interest rate of 10%. In that case, you’ll pay back £1,100 after one year.
If you borrow for a longer or shorter period, the interest rate might be different, as the bank tries to maximise its profits through the interest.
Understanding the interest rate
The rate of interest is simply the number before the percentage sign. The higher the number, the more you pay back (or the more you get back in the case of a savings account).
For example, a loan with a 5% interest rate will cost you less in the long run than a loan with a 10% interest rate, provided you pay it off in the same amount of time.
What about interest earned on savings?
There are two ways to think about earning interest, both of which are pretty simple to grasp.
The first, is to think of interest earned as the profit you’ll make on the total amount you have in savings.
For example, if you have a savings account with a 10% annual interest rate, and you have £1,000 in that account at the end of the year, you’ll earn £100 in interest.
The second way of understanding interest earned, is simply to think of yourself as the lender. When you open a savings account, you’re lending your money to the bank (it will use your money for its activities, but keep your money protected by law) and you’re charging them, for example, 10% for the privilege.
So in summary, interest is either/both:
- The cost of borrowing money
- The profit you’ll make on lending money
The interest rate is the amount of interest being charged or received (e.g. 5% or 1.5%).
What about APR?
You’ve probably seen credit card ads that have numbers printed on them in huge, bold fonts: 17% APR or 23% APR.
This stands for Annual Percentage Rate. It’s the same as an interest rate, only with any fees also included, which is why these percentages usually look much higher than the ones you see on say, a savings account.
Variable vs Fixed interest
There are subcategories within Fixed and Variable interest rates, but these are the two main types.
A Fixed interest rate means that the interest rate won’t change for the duration of the agreement (e.g. 12 months or five years, whatever it is).
A Variable interest rate can vary throughout the term, according to market conditions.
The most common place to see Fixed and Variable interest rates is on mortgages. A 5-year Fixed Term mortgage with a 5% interest rate, will have a 5% interest rate, no matter what, for that entire term.
The same mortgage with a Variable rate, might start at 5% in year one, move to 6.5% in year two, then drop to 4% in year three.
The advantage of a Fixed rate is that you always know what you’ll pay, but if markets drop, you won’t be able to take advantage. With a Variable rate, you might pay more during the term, but you also might pay less, making it more of a gamble.
Paying taxes on interest
If you have a savings account that isn’t an ISA, you’ll need to pay income tax on the interest you make. However, it’s very likely that as a UK adult, you’ll have an allowance which allows you to earn up to £1,000 in interest before paying any tax on it.
What is compound interest?
Compound interest can work for you, or against you. In a nutshell, compound interest is interest that’s been added to an amount, which has already had interest added to it.
The bad news is that if you have a loan which you’re paying back over a long period of time, the interest charges can mount up, as interest is added on top of interest.
The opposite is the case with a savings account. Let’s say you have £1,000 in a savings account that’s earning 1% interest. After 12 months you’ll have £1,010. The longer you save, the more pronounced the effect of compounding.
The more you know about interest rates the better. That way, you can make sure your money is working hard for you. Knowledge is always key when it comes to managing your money.
Want to learn more? Check our article on Saving 101.