What are interest rates and what do they mean?
A high interest rate can help if you are saving by adding more money to your deposit. A low interest rate can benefit if you are a borrower as less money is added to what you already owe.
What are interest rates?
When borrowing money, it’s common to pay a bit extra to the lender putting up the cash to make it worth their while. In other words, if you take out a loan, you’ll need to repay the lender more than the amount you originally borrowed. Conversely, if you deposit money into a savings account, the bank or building society will pay a bonus payment to you in return.
The name of these payments is interest and it’s typically expressed as an annual percentage of either the total amount borrowed or saved.
How are interest rates calculated?
To get a decent grip on your finances, it’s important to know how much interest you’ll owe or receive. Let’s start by looking at a basic example. A 5% yearly interest rate on a £2,000 loan or savings balance translates into an annual charge or return of £100. This can then be broken down monthly by dividing that £100 by 12 to give £8.33.
Calculations get more complicated when factoring in compound interest: interest added to previously earned interest. Using the above example, if you put the money away for 20 years in a savings account at the same 5% rate, you’d actually end up with £5,306.60, rather than the £4,000 that you might predict (£2,000 deposit plus 20 annual payments of £100). That’s because each time an annual interest payment is deposited it increases the total balance that the next year’s interest is calculated on.
Unfortunately, when compound interest is applied to loans the opposite happens: you pay interest on the sum originally borrowed as well as on the interest accrued. This can turn into a nasty surprise, particularly when repayments are small and compounding is calculated on a daily basis.
How are interest rates set?
The amount of interest you’re quoted depends on several factors, including:
- The Bank of England base rate: Each central bank, the authority responsible for managing the currency and economic policy of a country, sets an interest rate it charges high street banks. In the case of the UK this is the Bank of England. Its base rate is designed to influence the spending habits of the population and has a knock-on effect on how much we pay or earn on loans and savings.
- Expenses: Financial institutions normally take the central bank’s interest rate and tweak it to cover their expenses and generate a profit. Loans regularly carry a higher rate than savings and are typically advertised at an annual percentage rate (APR), detailing the total cost of borrowing – interest rates plus fees – each year.
- Demand: When banks are short on money, they may increase rates on saving accounts to encourage savers to deposit money with them. Alternatively, if demand for loans is low, they might reduce rates, to incentivise borrowing.
- Risk: The greater the perceived risk that a loan won’t get paid back, the more the lender will charge. Factors taken into consideration include the borrower’s credit rating, the length of the loan, whether it’s backed by collateral and the sum requested.
How do interest rates affect personal finances?
Interest rates influence the amount people spend or save and, therefore, have a big bearing on our finances.
If you wish to borrow money, it’s important to remember that the higher the interest rate, the more you’ll be charged overall.
Let’s consider a £150,000 mortgage to be paid off over 25 years. With a 2.5% interest rate, you’ll repay £673 each month. Push it up to 3.5%, and suddenly your monthly outlay grows to £751.
Interest rate rises can make it difficult to budget, which is why many borrowers opt to lock-in a fixed rate. Unlike variable interest rates, which lenders have the discretion to change at any time, fixed rates guarantee you’ll pay the same percentage of interest until an agreed date of up to 15 years. That’s reassuring but also means you could miss out on saving money if borrowing rates fall.
Savings accounts work in the opposite way: if rates rise, your bank or building society should pay you more interest. It’s important to think in “real” terms, though – if the advertised rate is 2% and inflation is running at 1.5%, your actual return, after accounting for the increased cost of living, is just 0.5%.
Other points to mull over include how often interest is distributed – the higher the frequency of payments, the more you earn from compounding – and whether to choose an account offering a fixed rate of interest, which might appeal if you don’t need to access your savings within the specified timeframe and believe interest rates will fall in that period.
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Daniel is a freelance finance journalist. He has written and edited news, deeper analysis features, and opinion pieces for the Financial Times, Investopedia and the Investors Chronicle. Read more