Interest
To manage money successfully, it is important to understand
interest and the impact it has on both the money we save and the
money we borrow.
This section explains how interest works.
You can read through this information sheet, or go directly to
the sections you want to read by clicking on these links:
Interest on borrowed money
When you borrow money you usually have to pay back more money
than you borrowed in the first place. This is because the bank,
building society or other company that you are borrowing from
expects you to pay them in exchange for lending you the money. They
do this by getting you to pay back some extra money every time you
make a repayment. This is called interest.
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Interest on savings
when we put money into a bank or building society account, this
situation is reversed. Our money does not just sit there until we
need it again. Instead, what we do is lend our money to the bank or
building society so that they can use it to do other things, such
as lending it to someone else. In return, the bank pays us
interest.
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Compound interest and the impact it has on your savings or
debts
- If you have ever had any savings or debts, you will know
already that they tend to grow on their own. This is good news if
you are saving, but not so great if you are trying to pay back
money you have borrowed.
- This growing is caused by compound interest, which works like
this:
- If you have borrowed money, as well as paying back interest on
the original amount, you also have to pay interest on the interest
you build up until you manage to pay back everything you owe
- With savings, you do not just earn interest on the original
amount of money you saved, you also earn interest on your interest,
which means the amount of money you have keeps growing.
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Interest
Interest rates
Whether we are borrowing money on a credit card or as a loan,
mortgage or overdraft, we have to pay interest, but how much we pay
can vary a lot. This is because interest is charged at different
rates depending on the type of borrowing. The rate of interest paid
on savings can vary too, with higher rates of interest often paid
if we agree to put our money in the bank or building society for a
longer time or we have a lot of money to put away.
Interest rates can also go up and down, which means that if we
borrow money we often end up paying different rates of interest
throughout the lifetime of our loan. Some of the time it is
possible to fix interest rates, either for a certain amount of time
or for the length of the loan, which means fluctuating interest
rates will not have an impact on our repayments
And if we are saving, some of the time we might get more
interest because of higher interest rates, while at other times our
savings earn less because of lower interest rates.
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Thinking in percentages
It is important to know that interest is usually talked about as
a percentage rather than an amount of money.
If you borrow money, you are usually given the figure for the
interest you need to pay as a percentage. For example, you may
borrow £500 at an interest rate of 5%. This means you’ll need to
pay back the borrowed sum of £500 plus another 5%, which works out
as £25.
Likewise, if you have £500 in savings in an account that pays an
interest rate of 5%, you’ll get £25 in interest.
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Annual Percentage Rate (APR) and Annual Equivalent
Rate (AER)
The letters APR and AER are often included in advertisements for
financial products such as credit cards. It is important to
understand what they mean in relation to interest when you are
considering borrowing money or putting your money into savings
accounts.
APR stands for Annual Percentage Rate and helps
you understand how much you will be charged for borrowing money to
make it easier for you to compare the cost of borrowing. All
official money lenders – for example banks, building societies or
loan companies – are required by law to tell you what their APR is
when you borrow money. They do this by adding the interest charged
over a year together with any other costs, such as arrangement
fees. By looking at APRs you can see at a glance which deals are
the best value, for example a loan with an APR of 4% will cost you
less to pay back than a loan that has an APR of 5%.
AER stands for Annual Equivalent Rate and is
used to show us how much interest we would get if we saved our
money into an account and left it there for a year. As with APR, it
makes it easier for us to work out which is the best deal.
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Last updated: 7 October 2011
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