Interest rates explained

Money Advice Service

When you borrow money for anything from a mortgage to a credit card, the amount you pay back is dictated by the interest rate, plus any additional fees. The same goes for saving, on which you earn interest. Understanding how interest rates work will help you prepare for any interest rates change.

What is an interest rate?

Interest is the cost of borrowing money typically expressed as an annual percentage of the loan.

For savers it is effectively the rate your bank or building society will pay you for borrowing your money. The money you earn on your savings is called interest.

Interest charged on a loan

Research from the Money Advice Service reveals 75% of homeowners haven’t considered how an interest rate rise would affect their mortgage repayments. A lack of preparation could cause you major problems should rates change, so it makes sense to ensure you have a firm grip on your income and outgoings.

When you borrow money, you’ll pay back the original amount loaned (called the ‘capital’) plus the interest.

Let’s say you borrow £1,000 from a bank:

If your loan attracts an annual interest rate of 10%, you will have to pay back £1,000 plus 10% interest (£100). So £1,100 is the amount you will have to pay back after one year.

The total could be more or less if you borrow the money over a longer or shorter period of time.

Interest earned on savings

If you place £1,000 in a savings account earning 2% interest annually you will earn £20 in interest, giving you £1,020 after one year.

Again, the interest you earn could be more or less if the rate of interest changes or the balance within your savings account fluctuates during the period that the interest was calculated.

How do interest rates work?

The Bank of England sets the bank rate (or ‘base rate’) for the UK. The current rate is 0.75%.

This can influence the interest rates set by financial institutions such as banks. If the base rate goes up, it’s likely lenders may want to charge more as the cost of borrowing increases. This works in exactly the same way for savers. If the BoE base rate rises you would expect to see the interest you earn from your savings to increase. Your savings provider has effectively borrowed your money.

What is APR?

When you borrow money, your lender will often advertise an ‘APR’ (Annual Percentage Rate). This is slightly different from the interest rate because it is made up of the interest rate plus any fees that are automatically included in your loan (for example, any arrangement fees).

The APR is particularly useful as it provides a benchmark when comparing similar financial products.

Find out more about APRs on MoneySavingExpert 

How does compounding work?

Read the transcript of the video (DOC 22KB)

Compound interest is calculated by adding interest to your loan or savings where interest has already been charged or accrued. This means that the added interest charged or earned from previous periods will also have been applied.

For example, let’s say you put £1,000 in a savings account earning 2% interest. After 12 months you’d have £1,020. The table shows how your savings would grow at different rates of interest, and the impact of compounding. The longer you save for, the greater the effect of compound interest.

Term 0.50% 1% 2%
Year 1 £1,005 £1,010 £1,020
Year 2 £1,010 £1,020 £1,041
Year 3 £1,015 £1,030 £1,062
Year 4 £1,020 £1,041 £1,083
Year 5 £1,025 £1,051 £1,105

Tax on Savings Interest

If you are a UK Taxpayer, you will probably have to pay Income tax on the interest you earn on your savings. Having a Cash ISAs is probably the main exception to this rule.

In April 2016 a new personal savings allowance was introduced which means most UK adults can earn up to £1,000 interest on their savings without paying tax if they are a basic rate tax payer. Higher rate tax payers can earn £500 interest tax free.

This article is provided by the Money Advice Service.

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