What is interest?

Interest rates are important for both borrowers and savers.

Borrowing costs money. Whether you’re taking out a mortgage or want a credit card, your lender will charge you a percentage of the money that it has lent you. Similarly when you put your money into a savings account, your bank pays you a percentage of that money back. This is known as interest. In this guide we explain how interest works and how you can compare interest across a range of products using APRs and AERs.

How does interest work?

Interest when you borrow money

For borrowers, the interest rate offered by your lender dictates how much you will need to pay to borrow that money. Your repayments will usually be made up of capital repayments and interest charges.

Interest when you save money

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

Interest payments will be paid into your account usually on an annual or monthly basis.

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 lower the rate, the lower your monthly repayments will be and the less you will pay for the loan overall. Some mortgages offer fixed rates (eg 2.49% for five years), while others will be variable based on the Bank of England base rate (eg base rate +1.54% for two years).

The best option for you will depend on your financial circumstances and the current economic climate. 

Fixed-rate mortgages give you the certainty that your mortgage repayments won’t rise for an agreed period but you won’t save any money if interest rates fall. 

Variable-rate mortgages will go up when interest rates rise and come down when they fall. How closely they mirror the Bank of England base rate depends on the lender, only specific tracker mortgages need to mirror them directly.

Can I stop paying interest?

You can’t avoid paying interest on personal loans or mortgages, but with credit cards, interest is entirely optional.

All credit cards have a brief interest free period and if you pay off your credit card bill in full, every month, you will not pay any 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 2 years or more. These are useful for spreading the cost of large purchases without paying interest on top. You need to keep up with repayments and pay off the balance before the interest-free period ends, however. 

When used sensibly, credit cards can also help you build your credit rating. 

Compound interest

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

This is bad news for borrowers but good news for savers.

For example, if you have a credit card and do not pay it off in full, interest will be added to your bill and over time, you are likely to start being charged interest on interest. This is why credit card debts can quickly spiral and take a long time to clear if you only make minimum repayments.

The same applies to savings, but in reverse. If you leave your savings untouched your interest payments will boost your balance and over time you will start earning interest on your interest.

Take a savings account with £1,000 in it that pays 2% interest. In year 1 you would earn £20 (1,000x0.02) but £20.40 in year 2 (1,020x0.02) as the interest you earned went back into the pot.

Base rate and other interest-rate jargon

The Bank of England sets 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?

Before you take out a credit card or loan lenders must tell you the annual percentage rate (APR).

This helps you understand how much you will pay to borrow the money and to compare the cost of different loans or credit cards. In addition to the amount of interest you pay over the course of the year for a loan, APR will also take into account any compulsory fees you will need to pay.

Confusingly the APR advertised for credit cards only has to be given to 51% of borrowers. The APR you get will depend on your credit score so it’s important not to take advertised rates at face value.

The advertised APR is known as the representative APR while the APR you get is called your personal APR. A personal APR could be higher or lower than the representative APR, depending on your credit score.

What about APRC?

This stands for Annual Percentage Rate of Charge - similar to APR it is used to compare the costs and associated fees of mortgages and secured loans. However unlike APRs it shows the annual cost of the loan based on its entire term and reflects that you may pay a lower interest rate in the early years.

This can be great in helping you see through lenders' often opaque pricing.

Some mortgages have tantalisingly low interest rates but eye-watering fees, while some charge higher rates but more competitive fees - the APRC helps you see which will one work out cheaper over the long run.

What is a good APR or APRC? 

If you're borrowing money with a loan, a mortgage or a credit card, you want to get the lowest APR or APRC possible. Generally the bigger the loan, the lower your APR will be, with credit cards and personal loans charging higher interest rates than mortgages.

You want to get a rate as close to the Bank of England base rate as you possibly can, but bear in mind that with credit cards you may be able to get interest-free borrowing and you may get an 0% APR for a limited period.

What is AER?

AER or Annual Equivalent Rate is very similar to APR, 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. 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.