Interest rates

When we’re talking about money, the word ‘interest’ usually crops up in two different places. You hear people talking about the amount of interest they have earned on savings and also how their debts are growing because of interest.

But what exactly is interest?

Well, a good way to understand it is like this: The money in a bank or building society doesn’t just sit there. What you and other customers are doing is actually lending your money to the bank or building society to fund their activities. In return for this, they pay you an extra bit of money, which we call interest. How much interest you earn depends on where you put your money and how long you save it for.

At the other end of the scale, if you borrow money, whoever you’re borrowing it from, usually charges you interest in exchange for lending you the money. They tend to do this because they want to make a profit on their money and because there’s always some risk involved in lending people money. Out of the people you know, think about who you’d trust to pay you back if you lent them some money. Some would be sure to pay you back promptly while others would vanish forever, taking your money with them. Companies lending money face the same situation. You’ll find that if you haven’t paid back money in the past, you’re likely either to be turned down when you ask to borrow money or charged a lot of interest. Not understanding about interest and how it piles up is one of the easiest ways to get into debt. Unfortunately, working out how interest is charged is complicated.

When we talk about how much interest we’re being charged, we usually talk about it as a percentage of the amount we’ve borrowed. For example, we may say we’ve borrowed £1,000 at an interest rate of 10%. This means as well as paying back the original £1,000, we need to pay back another 10% on top of that, which works out as £100. Unfortunately, working out how much interest you’ll be paying isn’t as easy as this because of something called Compound Interest.

Compound interest

Compound Interest means that as well as paying back interest on the original amount you borrowed, you also have to pay interest on the interest that has already built up. This means that the longer you have your debts the more they grow.

APR (Annual Percentage Rate)

If you’re borrowing money, you’ll come across the letters APR. This stands for Annual Percentage Rate. Anyone officially lending you money has to tell you what their APR is. They work this out by adding together the interest you’ll be charged over a year plus any extra costs such as arrangement fees. The idea behind APRs is that they make it easier for you to compare the cost of borrowing. For example, one company might have an APR of 5% while another has one of 10%. (The lower the APR, the better.)

AER (Annual Equivalent Rate)

If you’re saving money, the letters you’ll come across are AER. This stands for Annual Equivalent Rate. This shows how much interest you’d get if you put some money into an account and left it there for a year. Again, using AERs, you can work out which bank or building society will help your savings grow fastest. (The higher the AER, the better.)

The ‘Money Matters to Me’ website has a number of calculators that can help you understand interest:

To work out how much you’ll be paying if you take out a loan, go to: www.moneymatterstome.co.uk/Interactive-Tools/LoanCalculator.htm

To work out how your money will grow if you save it, go to: www.moneymatterstome.co.uk/Interactive-Tools/GeneralInterestCalculator.htm