Interest Rate Types

The cost of borrowing money is known as interest. Therefore, when you take out a loan, the money you pay back in addition to the initial amount is the interest. When you deposit money in a bank, the amount the bank pays you to keep the money in that account is also called interest. This is because the bank is effectively borrowing money from you. The interest rate is normally determined as a percentage of the original sum.

Simple Interest (also known as Nominal Interest) 

Simple interest is interest based on the original loan or saving amount. 

For example, if you deposit £1,000 into a bank account and earn 2% interest per annum, after one year you will have £1,020. The same applies if you borrow money. If you borrow £1,000 at 2% interest per annum, after a year you would owe £1,020.

The above examples are very simplistic and don’t account for withdrawals or payments.

Compound Interest 

Compound interest is more complicated. Rather than a percentage of the initial sum being continuously added to the final amount, the percentage is applied to the most recent sum. For example, if you deposit £1,000 into a bank with compound interest of 2%, after a year you would have £1,020, and after the second year you would have £1,040.40 as the 2% interest would have been applied to £1,020 rather than the original £1,000. 

The difference does not seem like much, however, after a number of years and with a larger sum of money, the figures will accumulate. Compound interest can also apply to borrowing money, and you would owe £1,040.40 rather than £1,040 after two years. Banks generally apply compound interest to money that you borrow or save.

Borrowing Money

When borrowing money with a credit card, loan, or mortgage, there are two interest rate types: Fixed Rate Interest and Variable Rate Interest.

Fixed Rate Interest

Fixed Rate Interest offers borrowers a fixed interest percentage to pay back over an agreed period of the loan. This helps borrowers to calculate their repayments as the fixed rate is unaffected by market increases. However, the repayments will also not go down should the market rate decrease. A fixed rate helps take away the risk of not being able to pay an unexpected higher monthly repayment, but also removes the possibility of benefiting from lower monthly payments should the market rate go down.

Variable Rate Interest

Variable Rate Interest allows the lender to increase or decrease the interest rate at any point during a credit agreement, normally but not always as a result of fluctuations in the market base rate. A borrower on a variable rate risks being less able to afford the repayments if the interest rates rise, but is able to benefit from more affordable repayments if rates fall.

Interest Measures

Interest can be calculated per year and per month, which can make it difficult to compare quotes from product providers. There are also surrounding costs, such as administrative fees, that can affect how much you are paying.

To calculate such costs, there are measures called the annual percentage rate (APR) and the annual equivalent rate (AER). These are universal measures that can help you to compare the overall interest you will pay, or be paid by, a product provider over a certain period of time.

Annual Percentage Rate (APR)

The annual percentage rate represents the annual rate of interest that is payable on mortgages, loans, credit cards and other credit products – it tells borrowers how much it will cost to borrow, including interest as well as any upfront fees the lender charges. This is calculated as a combined annual percentage rate, paid over the duration of the loan.

Mortgage adverts could also quote a ‘headline’ rate alongside its APR. The headline rate tells you what the basic interest rate is without taking fees into account, while the APR advertised includes fees and is normally higher than the headline rate.

Lenders often advertise a standard APR and will then review your credit history, and personal situation to determine the actual interest rate they are prepared to lend you for the amount you wish to borrow. However, the standard APR advertised must be offered to at least 51% of consumers.

If you are refused credit, the lender should tell you why your application was refused and the details of the credit reference agency they used. Understanding your credit report can help you work towards improving your credit score. Learn more about credit hygiene and what can affect credit scores. 

Annual Equivalent Rate (AER)

The annual equivalent rate tells you how much interest your money will earn over a year, taking into account whether you are paid monthly or yearly, and how the interest is compounded. For example, if you were to deposit money into two savings accounts, one that paid interest monthly and one that paid annually, the interest rates would differ due to the benefits of compounded interest for the monthly account. As a result, an account that pays monthly interest may offer a lower interest rate compared to an account that pays yearly interest, yet their AER or the interest you get at the end of 12 months, could be the same.

This article was updated on 27 April 2022; all information was correct at the time of writing.