Understanding interest rates

Today, we’ll be zooming in on interest rates. What they are, why they exist and how they impact you. Let’s get started.

What is an interest rate?

When you borrow money, interest is the charge you pay for using it. It’s often shown as an annual percentage of the loan or credit card amount.

When you save money, the bank or building society borrows your money and pays you interest in return.

What is APR?

Annual Percentage Rate (APR) is slightly different from interest rates. It includes the interest rate plus any fees that are automatically included in your loan (such as processing or broker fees).

How does compound interest work?

Compound interest works through you receiving interest both on your original amount and then also the interest that has already been added.

This means you then earn interest on this new, larger amount.

Who sets interest rates?

The Bank of England (BoE) sets the bank rate - otherwise known as base rate - for the UK.

The bank rate can influence interest rates set by financial institutions such as banks. If the base rate goes up, lenders will probably want to charge more as the cost of borrowing increases.

This works both ways, though. If you’re saving, you can earn higher interest on your savings.

Fixed vs Variable interest rates

Fixed interest rates are unaffected by Bank Rate changes. In terms of borrowing, loans may be offered at a fixed interest rate for the full term. With a fixed rate, you’ll be able to calculate interest or repayments over time.

Some types of borrowing may offer fixed rates for an introductory or promotional period.

The risk with a fixed rate is if interest rates drop, as you may still be locked into a higher rate.

Variable interest rates, however, can go up and down. This is often influenced by Bank Rate changes.

Variable interest rates could apply to any type of financial account, from savings and mortgages to credit cards and loans.

As the name suggests, when market interest rates are low, you could benefit from low borrowing costs. However, when rates climb, pressure may be placed on your finances.

How can interest be applied differently?

Interest may be applied differently to a mortgage, loan, credit card, savings or a current account.

On bank accounts

You can earn either fixed or variable interest as mentioned through bank accounts. If you’re a UK taxpayer, you may need to pay income tax on interest you earn over and above your personal savings allowance.

On a mortgage

With a repayment mortgage, you pay more towards interest at the start, and less as you reduce your balance during the mortgage term.

Variable rate mortgages mean that the amount of interest you pay will be in line with interest rates, and will fluctuate. A tracker mortgage is one example of a variable rate mortgage. It typically follows the Bank Rate.

On a personal loan

A personal loan can offer a fixed borrowing amount, and you pay interest as part of your monthly payment amount.

Much like variable rate mortgages, you can get loans that have variable interest rates. So while your term may be fixed on these loans, your monthly payments could change over time.

You can sometimes make overpayments on some loans without incurring early repayment charges, which could reduce the term and amount of interest you pay overall.

If you settle your loan in full before the end of the agreed term, early repayment charges may apply.

On a credit card

Interest is charged as a percentage of what you’ve borrowed, although the rate may vary depending on the transaction type.

If you repay your balance in full each month you can avoid paying any interest.