What are interest rates?

Interest can be a cost to you when you borrow, or a reward when you save.

Interest is charged on borrowing

When you borrow money, whether that’s in the form of a mortgage, credit card, personal loan, overdraft or car finance, you may need to pay a percentage of interest – essentially, a charge for borrowing money.

In addition to repaying anything you borrow, costs may include interest, fees and other charges.

Or earned on savings

When you save, the financial institution you deposit with may reward you with a percentage of interest, paid to you either monthly or annually.

How do interest rates work?

There’s no simple answer to this question, but the following information may help:

The Bank Rate

Sometimes called the ‘Bank of England Base Rate’, the Bank Rate is set by the Monetary Policy Committee, working with the government to keep inflation low and stable.

The Bank Rate sets the amount of interest paid to commercial banks, which in turn influences the rates they charge customers for borrowing, or pay them for saving.

If the Bank Rate increases:

  • Unless your interest rates are fixed, the cost of borrowing will go up.
  • Interest earned from savings will increase.

If the Bank Rate decreases:

  • The cost of borrowing at a variable rate will go down.
  • Interest earned on savings will decrease.

Simple interest

As the name suggests, this is a simple calculation of potential interest, based on the original borrowing or savings amount only, not accounting for payments or withdrawals.

Here are some very simplified examples:

  • If you borrowed £1,000 at an annual interest rate of 16.9%, after a year you would owe £1,169.
  • If you saved £1,000 at an annual interest rate of 2%, after a year you’d have £1,020.

Compound interest

This is where things get a little more complicated. Compound interest accounts for the effect of interest on interest charged or earned over time.

Here’s an illustrative example of compound interest on savings, at an annual interest rate of 3%:

Year

Balance

Annual interest

Closing balance

Year

1

Balance

£1,000

Annual interest

£30

Closing balance

£1,030

Year

2

Balance

£1,030

Annual interest

£30.90

Closing balance

£1,060.90

Year

3

Balance

£1,060.90

Annual interest

£31.82

Closing balance

£1,092.72

Although the difference may seem slight, over a number of years and as your balance fluctuates, this could make a significant difference to the interest you pay or earn.

Fixed interest rates

Unaffected by Bank Rate changes, a fixed interest rate could make it easier for you to calculate interest or repayments over time.

In terms of borrowing, loans may be offered at a fixed interest rate for the full term. Other types of borrowing may offer fixed interest rates for an introductory or promotional period.

It’s worth knowing, by fixing your interest rates on borrowing, although you’ll be sheltered from increases in your borrowing costs when interest rates climb, you won’t benefit when rates decrease.

Variable interest rates

These interest rates can go up and down, often influenced by Bank Rate changes.

Variable interest rates could apply to any type of financial account, from savings and mortgages to credit cards and loans.

When market interest rates are low, you could benefit from low borrowing costs, but your repayments could climb as interest rates increase, potentially putting pressure on your finances.

Consider other fees and charges

Annual or monthly account fees and other charges may apply to current and credit accounts. In addition, you may need to pay tax on any income from savings and investments.

What is APR?

APR stands for Annual Percentage Rate. It factors in your interest rate and any other standard fees, meaning the APR offers a more complete picture of your borrowing costs over a year.

What is AER?

AER stands for Annual Equivalent Rate. It indicates how much interest you could earn on savings within a year, factoring how regularly interest is paid, and how it is compounded.

Promotional interest rates

Many lenders offer fixed, low and even 0% interest rates on selected credit products, which could help you to manage your borrowing needs and limit costs, for a defined period of time at least.

These are often introductory or promotional offers, so it’s important to check the terms and conditions, and to understand exactly when any offers expire, just to keep a handle on your borrowing costs.

As an example, imagine you’re accepted for a credit card offering 0% interest for 12 months on balance transfers made within 90 days of account opening.

If you repay your full balance by the end of the 12-month offer period, and don’t use your credit card for anything else, you won’t pay any interest at all, although a transfer fee may apply.

If you did go on to make purchases using your credit card, unless a 0% interest rate applies, to avoid paying interest on purchases, you need to pay off your statement balance in full and on time every month, including any transferred balances.

How interest rates work:

  • On current and savings accounts, the interest you earn could be either fixed or variable, depending on the terms of your account.

    Interest is paid on the balance you hold in your account, e.g. for a savings account which pays interest annually, if you have £1,000 in your account for 12 months, you’ll receive interest on that balance.

    If you’re a UK taxpayer, you may need to pay income tax on interest you earn over and above your personal savings allowance. If you’re a saver, an ISA could be one way to manage your tax liability.

    An overdraft on a current account could be useful as a short-term safety net, helping you to manage unexpected costs, or simply tide you over for a few days.

    Some banks and building societies will allow you to use an unarranged overdraft, however your credit score could be negatively impacted.

    Instead, you could apply for an arranged overdraft online, over the phone or in branch. You’ll only be charged daily interest if you use it, as detailed in the terms and conditions of your account.

    More about savings accounts 

    Learn about current accounts

  • Interest on a mortgage is always calculated as a percentage of your balance.

    For repayment mortgages, you pay more towards interest at the start, and less as you reduce the balance owed over the mortgage term.

    With interest-only mortgages your monthly payments could be lower, but you’re not reducing your balance during the mortgage term, and you’ll need to pay it in full at the end.

    Fixed rate mortgages

    If you’d prefer your mortgage payments to stay the same each month, you could fix your mortgage interest rate for anything from 2-10 years. Although you may not benefit if interest rates drop, you’ll be protected from rate increases.

    At the end of the fixed rate term a variable rate will apply, so you may want to switch to a new mortgage deal as soon as your fixed rate ends, helping you to manage your borrowing costs, but avoid any early repayment charges.

    Variable rate mortgages

    If you don’t mind your monthly payments being changeable, a variable rate could reduce your borrowing costs when interest rates are low. If interest rates go up, just be aware that your payments could increase, potentially putting pressure on your finances.

    A ‘tracker’ is one type of variable rate mortgage, typically following the Bank Rate.

    More about mortgages
     

  • A personal loan could offer you a fixed borrowing amount, over a term to suit your budget – typically 1-7 years. At the end of that term, your loan will be repaid in full, so long as you’ve made all of the required payments. Interest is included as part of your monthly payment amount.

    If interest rates are fixed your loan term and monthly repayments will be too, making it easier to keep track and understand your borrowing costs.

    If you choose a personal loan with variable interest rates, although the term will be fixed, your monthly payments could change over time.

    You may be able to make overpayments on some loans without incurring early repayment charges, which could reduce the term and amount of interest you pay overall. If you settle your loan in full before the end of the agreed term, early repayment charges may apply.

    More about loans

  • Interest is charged as a percentage of the money you’ve borrowed, but the rate could vary based on the types of transaction you make.

    You may find that a credit card has lower interest rates for one transaction type, such as purchases or balance transfers, but other rates may be higher, effectively defining the primary use for that card.

    Introductory and promotional interest rates may apply, offering low or even 0% interest for a period of time on qualifying transactions.

    To limit your interest costs, aim to repay any balances on an introductory or promotional rate before the offer expires, after which the standard interest rates will apply.

    You could avoid paying any interest at all if you repay your balance in full every month.

    More about credit card interest rates

How do lenders decide what interest rate to offer?

When assessing new credit applications, lenders will check against information from your credit record, as well as other factors like affordability and any past account history.

Key points about interest rates

You may pay interest when you borrow money, or earn interest when you save.

  • The Bank Rate sets the amount of interest paid to commercial banks, which in turn influences the rates they charge customers to borrow, or pay to them for saving.
  • In your calculations, it’s important to consider the impact of compound interest on both borrowing and savings.
  • There are benefits to both fixed and variable interest rates, depending on your specific needs.
  • Interest may be applied differently to a mortgage, loan, credit card, savings or a current account. Refer to your terms and conditions for full details.

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