Interest is the cost of borrowing someone’s money. When you are borrowing money, you pay interest. When you are lending money, you earn interest. We will explain the basics of how interest works and what it means for you.
How does it work
Borrowing money
In addition to the loan you may take with a lender, they will be compensated with ‘interest’ in return for the rick of lending money to you. The rate you pay will be usually be shown as an annual percentage of the amount you owe.
Saving money
If you have extra cash, you are able to lend it out yourself or through a deposit in a form of savings account (you are effectively lending them cash). In exchange, you will in return be paid interest, again usually shown as an annual percentage rate.
How much you pay or earn in interest will depend on:
- The interest rate
- Amount of the loan
- Length of time on the loan
The larger the amount of the loan and length of time on the loan, usually will attract a higher interest rate.
Types of interest
Interest rates offered by banks and building societies will be influenced by the ‘base rate’ set by the Bank of England. If it goes up, the cost of borrowing increase along with earnings from savings.
APR
APR is short for Annual Percentage Rate which is a type of interest rate offered. They basically show how much your borrowing will cost in average over a year for your borrowings. It will include the interest rate of the product and any associated fees.
It is a legal requirement for APR to be shown on personal loans, credit cards and hire purchase agreements. It must include all mandatory fees but does not have to include voluntary ones even if you opted out. Also, be aware that APR is an average so when applied to a credit card, it means the average rate offered and not necessarily the rate you will get.
APRC
Like APR this stands for Annual Percentage Rate of Charge which is now used for mortgages. It will effectively bring together all the charges (including the various fees).
Both rates allow customers to easily compare various financial products after all costs are included.
To avoid paying interest on products such as credit cards, ensure you pay off the full balance every month. This way, you won’t be charged interest on your credit card balance.
AER
AER or Annual Equivalent Rate is similar but applies to savings. This is the percentage rate you will earn if you don’t make any withdrawals in the year.
To get the highest earned rate, always compare accounts when looking to deposit your savings and find the best AER on the account to suits you. It is important to understand exactly what you must do to achieve the advertised AER such as ‘only one withdrawal per month’ for example. Another option is to find a card that offers interest free introductory periods that can range from 3 to 29 months. These can be useful for large purchases and spreading the cost over the length of the introductory period interest free.
