What is interest?

Borrowing costs money. A lender will usually charge a borrower a percentage of the money lent, rather than a flat fee. This is called interest. This guide covers the basics of how interest works, what it is and what it means for your finances.

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Interest rates are important for both borrowers and savers.

How does interest work?

Interest when you borrow money

For borrowers, the interest rate offered by your lender dictates how much it will cost you in addition to the amount you repay.

The rate you pay is usually advertised as an annual percentage of the amount you owe, though this rate can change over time.

Interest when you save money

For savers, the interest rate on your savings account indicates the return you will get for keeping money there.

When you save money with a bank or building society, you are essentially lending them your cash. Therefore they pay you interest in the same way you pay a credit card company when they lend you money.

Taking out a loan or a mortgage

When you take out a loan – or a mortgage if you're buying a house – your lender will offer you an interest rate. The amount that you owe will increase by this percentage until you pay it off.

Some mortgages offer fixed rates (e.g. 2.49% for five years), while others will be variable based on the Bank of England base rate (e.g. base rate +1.54% for two years).

The best option for you will depend on your financial circumstances and the current economic state. Taking out a fixed mortgage will give you certainty for a period of time, though a variable mortgage might save you money.

If national interest rates suddenly rise, a variable mortgage could leave with sharp repayment increases.

If interest rates fall and you have a fixed mortgage, you would be unable to take advantage of the cheaper cost of borrowing.

The below graph shows a fixed rate mortgage (orange) maintain the same rate as a variable mortgage (purple) fluctuates. In 2018 and 2019 the fixed rate is cheaper, but in 2020 it is more expensive.

Compound interest

This is where borrowing and saving gets a bit complicated. Your interest rate does not just apply to the amount you have borrowed or saved, but also to the interest accrued.

For example, if you are in debt and during a given period (usually a month or a year, though sometimes weeks or days) you do not pay off more than your interest rate, in the following period the rate of interest will apply to the amount you borrowed plus the interest.

This also applies to savings, but in reverse. If you do not withdraw more than your interest rate, you will start to earn interest on that amount too.

For example, a 2% savings account of £1,000 that pays interest annually would earn £20 in year 1 (1,000x0.02) but £20.40 in year 2 (1,020x0.02) as the interest you earned goes back into the pot.

Types of interest rate

The Bank of England set a ‘base rate’ that influences all other rates of interest. If it goes up, the cost of borrowing and the value of saving go up too. Find out more about how the base rate affects your finances.

The other main terms you will come across when borrowing or saving money are APR and AER.

What is APR?

APR or Annual Percentage Rate is a type of interest rate offered by banks. It includes the interest rate of the product, but also takes into account any fees. Therefore it is generally best to look out for the advertised APR when comparing, so that you know exactly what you will be earning or paying.

APR must include all mandatory fees, however it does not include voluntary ones, even if they require an opt-out.

Also be wary that APR is an average. For credit cards that means it is the average rate offered, not necessarily the one you will get.

How does APR work?

For loans it is calculated across the borrowing period. So even if your mortgage has a 3% APR, you may never actually pay 3% if your introductory rate is much lower and your rate after that is much higher.

What is a good APR for a loan or mortgage?

If you're borrowing money with a loan, a mortgage or a credit card, a good APR would be the interest rate available to you which is closest to the Bank of England base rate.

The base rate is the interest rate that your bank or lender would pay to borrow money from the Bank of England – essentially the best rate that it's possible to get.

You can use it as a guide to understand what a good rate would be, just don't expect your bank to offer the base rate to you.

What is AER?

AER or Annual Equivalent Rate is very similar, but applies to savings. It shows the percentage that your money will increase by if you make no withdrawals for a year. This is different to the gross rate due to the impact of compound interest.

While interest rates can seem complicated, the most important thing to remember is to always compare loans and credit cards by APR and savings by AER.

How do I earn the most interest?

Comparing savings accounts to find the best AER is important, but remember that some accounts come with perks that can be worth more than a low interest rate elsewhere. For example, free cinema tickets might be worth more to you than earning 1% interest on your savings.

On some occasions, standard bank accounts can offer better perks and interest rates than savings accounts, so make sure to compare high interest current accounts too.

It is also important to know exactly how much interest you will earn from an account, so use an interest calculator to find out.

Will I pay tax on my interest?

You do not need to pay tax on all of the interest you make on your savings if you qualify for a starting rate for savings, personal savings allowance or personal allowance.

Read our guide on savings interest and tax to find out more.

How do I stop paying interest?

One way to avoid paying interest on credit card debt is to pay off your balance in full every month. This way you won't be charged interest on your credit card spending. Another option is to get a 0% purchase card. These cards offer introductory interest free periods that can range from 3 months to 29 months. These are useful for spreading the cost of large purchase without paying interest on top, as long as you keep up with repayments and pay off the balance before the interest free period ends. When used sensibly, they can also help you build your credit rating. That said, paying interest isn’t always a bad option, for example taking an interest only mortgage, one way to keep your monthly repayments down. But as with all forms of debt, it's important to know you can afford repayments before you borrow.