Understanding Interest Rates

By | 11/08/2018

When you borrow money, you make payments towards what you have borrowed and this payment usually includes the interest that the lender charges for lending you the money. The amount of interest can vary, as can the terminology used to describe it but understanding what it means in real money terms is an important part of borrowing.

Basics of interest rates

If you borrow money at an interest rate of 5% a year, it will mean you will pay the amount due plus 5% – so if you borrow £100, you will need to pay back £105 to clear the debt. Interest rates are quoted annually but some lenders give it in different forms.

Similarly, if you save money and the bank account states that they will pay you a set amount of interest on the money you saved, you will gain that amount each year. So, a 1% saving rate where you saved £100 would gain you an extra £1 each year.

Annual Percentage Rate

In most cases, borrowing money will quote the interest rate as an annual percentage rate or APR. This figure is worked out include the interest charged for the borrowing as well as any fees that the lender is including. APR figures can be a bit confusing – for example, an interest rate can be 14% per year but the APR is 17% as this takes into account the fact that charges account for an additional 3% a year.

Sometimes, borrowers will give a figure on a monthly APR as this figure sounds smaller than the annual figure but can add up. So, a monthly APR of 2% equated to an annual figure of 27% including those fees as above.

Things to watch for with APR

APR is stated when you take a loan or a credit card but this figure can change during the life of the repayment. Mortgages are the classic example of this – you can take a fixed rate for a set period of time but once this ends, the rate becomes variable and the amount of interest charge can change on a monthly basis.

Another thing to watch for with APR is called representative APR. This means that 51 out of every 100 people who apply for the product will get the advertised APR but the rest might get a different figure. So, while the representative APR might be 19.9%, if you fall into the 49% of applicants, the APR you are charged might be higher. This doesn’t tend to apply to personal loans, where a single APR figure is quoted.

Annual Equivalent Rate

The other term to discuss interest rates is the Annual Equivalent Rate or AER. This is used for savings accounts and is a way to see the differences between accounts. It gives you an idea of what interest you would be paid if you put the money in the account and left it there for a full year. Alternatively, a figure would be a gross rate, the amount of interest that is actually paid.

There’s a great ‘real life’ example in this short video that should help explain further…