A Beginner’s Guide To… Interest
In the first of many guides here on 3MoneyTalk, we begin on a topic that will inevitably impact each and every one of us at some point in our financial lives; interest.
In a nutshell, interest is the cost of borrowing money.
However, this is a two way street.
Interest affects virtually every aspect of both your earnings and spendings, whether it’s gaining 3p a month on your miniscule-rate current account, or the eyewatering lump-sum you end up ‘overpaying’ back for the privilege of borrowing money to buy a house.
Here we are going to give a streamlined what you need to know introduction to the wonderfully banal world of Interest.
Interest rates are the percentage of the sum borrowed that you then pay back over time (on top of the original sum).
When you are presented with interest rates, you usually see them accompanied with either of two acronyms; APR or AER.
APR stands for Annual Percentage Rate
This is usually the base interest with other charges and fees lumped together, as a general percentage over a 12 month period.
AER stands for Annual Equivalent Rate
This rate is often tied to saving accounts, and allows you to compare the possible interest you’d receive over 12 months with other offers.
So how are interest rates set?
Well the National Bank, let’s say the Bank of England, lends money to ‘high street banks’ (your Barclays, Natwests etc), who then lend money to borrowers, as well as hold money deposited by savers.
The banks then generate their profits by charging you slightly (or substantially) higher rates on borrowing this money that they’ve borrowed off the National Bank, which enables them to offer loans and mortgages.
The Base Rate (National Bank rate) may be 0.5%.
The high street bank may charge 5% interest on loans.
This means the bank may gross (income before taxes/charges) 4.5% annual profit on this loan.
On the flipside, a share of this interest is also available to savers who deposit their money with the high street bank. Over time, money deposited by savers also gets used by the bank to offer as funding for loans and mortgages, so the profits of this borrowed money also gets split with savers.
This explains why your saver interest rates are sometimes higher than the Base Rate, as the bank has been able to use the your money to fund the giving of a loan to someone else, so you are rightfully due your share of the bank’s income generated from said loan.