understanding interest rates

It is crucial to understand how compound interest works as this is the basis for all saving and borrowing.


For instance, if you have £100 in a savings account which pays 10 per cent annual interest, after year one you will have £100 plus £10 interest (10 per cent on £100), or a total of £110. After year two, you'll have earned another £10 interest (the interest on the original £100), plus a further £1 of interest earned on the £10 interest from the first year. So now you've a total of £121.


By year three, you'll be receiving interest on the interest from year two, and interest on the interest on the interest from year one. So that how compound interest works.


This means that your money grows more quickly because you don't just earn interest on the money you originally saved, but you also earn interest on the interest, and it goes on. This makes a big difference as the longer you save for, the greater the effect.

Let's say you put that money away for 20 years. If you were only earning the £10 a year, without the compounding, you'd have £300 in the bank at the end of 20 years. However because of the interest on the interest you actually have £670.

Interest on debts clocks up quickly, too 

While this is great for savers, the same applies if you are paying interest to borrow money. This is because you will be paying interest on the original loan amount and interest on the interest accrued.

So the longer you borrow for, the quicker your debts mount up. Unfortunately, compound interest tends to have an even bigger impact on debts than on savings, because interest rates on loans, credit cards and mortgages tend to be higher than for savings.

For instance, if you borrow £1,000 at 10 per cent over twenty years without making any repayments, your debt will grow to £6,700, whereas without compound interest, your debt would only be £3,000.

To work out roughly how quickly your debt will double, divide 72 by the annual interest rate. For instance, 72 divided by 7 per cent equals 10.3 years. Although this is a useful rule of thumb, it is less accurate for rates over 20 per cent.

Annual percentage rates

APR stands for the Annual Percentage Rate. When lenders calculate their APRs, they have to include both the cost of the borrowing and any compulsory associated fees, such as arrangement fees that are automatically included, so that you know the overall cost of your debt.

The fact that the APR must include all charges means that the figures you are shown can be a bit confusing. For instance, the interest rate might be 14 per cent a year, but due to other charges the APR is 17 per cent.

Problems with the APR rate

While it all sounds good so far, unfortunately there are a number of problems with APRs. Here are two of the main things to watch for.

  • APRs on personal loans

    If you take out a personal loan, many lenders automatically include payment protection insurance in their quotations. Although this insurance is supported to be voluntary, it is up to you to tick a box to opt out of it. If you don’t, PPI will be automatically included in your interest repayments, but not included in the APR calculation because PPI isn’t compulsory.

This means that some lenders subsidise their personal loans with expensive PPI insurance, so that what looks like a cheap personal loan interest rate is actually more expensive than one which has a higher interest rate (but with no hidden PPI included). So a 5.7 per cent APR loan with PPI could cost you more in practice, than a 7 per cent APR loan with no PPI.

  • APRs on mortgages

    The APR is meant to indicate the amount you will pay each year over the full term of the debt. But unless you take out a fixed rate mortgage over 25 years, it is difficult to gauge how much you will pay if you only have a mortgage for a few years before switching.

 

This is because a mortgage APR is calculated by taking the total interest cost over the 25 year term of a mortgage, plus fees ( and this figure must be included prominently in mortgage adverts and documentation).

So a mortgage  with a 6.6 per cent APR could be for a 4.5 per cent fixed rate for two years, followed by 6.75 per cent  variable rate for the remainder of the term. The 6.6 per cent represents the average cost if you were to continue with that mortgage for the full 25 year term and assuming that the variable rate remains at 6.6 per cent, which is highly unlikely.

AERs on savings account

The AER or Annual Equivalent Rate is the official rate for savings accounts, and is designed to allow easy comparison across different savings accounts.

The idea is to show what you'd get over a year if you put your money in the account and left it there. The alternative is the gross rate, which is the flat rate of interest that's actually paid.

The main thing to watch out for is that you compare like with like. AER or the gross rate. Both are gross of tax.


Effect of annual or monthly interest.

If interest is paid annually, then the annual and gross rate AER should be the same, as there's no compound interest.

If interest is paid monthly, then the gross rate given is usually around 0.1 per cent less than the monthly AER rate. This is because if the monthly interest is left in the account, there is interest being earned on the interest, too.

So for an identical account, if it pays interest monthly it would be a 5 per cent AER rate, but if interest is paid annually it would be 4.89  per cent gross.

Bonus rates of interest. The second confusion is the impact of introductory bonus interest rates on AERs If a bonus is being paid for six months, then the AER (which stands for Annual Equivalent Rate), would be less than the gross rate for the first six months as it would need to include the period pre- and post-bonus.

However, if you're planning to move accounts when the bonus rate ends, then the AER is irrelevant, as you only need to know the interest rate during the bonus period. So, in this case, you should switch rates and compare gross rates (and be sure to take note of whether it's monthly or yearly interest).