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Ten Pound Notes

Interest explained

Interest can make you money. It can cost you money. It can be confusing. Ironically interest isn’t that interesting. But these 9 Basics should sort you out.

1. SO INTEREST IS GOOD?

Interest is earned on money that you save. Good. It’s also charged on money you borrow. Bad. Interest is measured by a percentage that’s called the interest rate. So interest is when you earn/pay a percentage of the balance.

2. WHEN DOES IT HAPPEN

It depends. It could be daily, monthly or annually. Most interest payments on borrowings are applied monthly (unless you have a 0% balance transfer or 0% spending credit card with a period of no interest on the debt).

3. INTEREST GOES ON THE INTEREST TOO

Each time you earn or pay interest, you’ll also earn or pay interest on any interest already accumulated. This is known as compound interest. For example if you borrow £100 on a 20% APR credit card and make a minimum payment of £5, your balance owed the next month will be £115 (£100 plus £20 interest minus £5). The month after it will be £133 (£115 plus £23 minus £5). And so on.

4. A.P.ARRRGGGHHH!

AER stands for Annual Equivalent Rate. This is the interest you earn on any savings if you had them for a year.

APR is the Annual Percentage Rate charged when you borrow money through a credit card, mortgage or loan. So this is the rate you’ll pay on the debt if you had it for a year. This normally contains any fees you are charged as part.

EAR is Equivalent Annual Rate and is charged on overdrafts (see our 6 Basic Banking Terms). It doesn’t include any fees. Just the compound interest if your account remained overdrawn for 12 months.

5. ANNUAL? SO MONTHLY RATE IS DIVIDE BY 12?

Interest rates are normally averaged over the year and including most fees. Unless specified (e.g. a fixed savings account) you don’t need to keep savings or a debt for the full year. The annual rate just helps you compare. So if the rate is 4% AER, you don’t earn that each month, but by the end of 12 months you will have. Instead, because of compound interest, the monthly interest rate will probably be less.

For example £100 savings with a 12% AER interest rate would earn £12 interest at the end of a year. 12% AER divided by 12 equals 1%, but if you add that on each month the amount earned would be £112.68. So the real monthly rate works out as 0.94%.

6. REPRESENTATIVE RATE

If you see ‘Representative Rate’ on ads for credit cards, loans etc, this is the average rate the bank gives. You might get a higher or lower (far less likely) rate on your borrowings.

7. BONUS RATE

Bonus Rates are usually found on saving accounts. They will promote a higher rate for a period of time. E.g. a rate of 1.5% AER including a bonus of 0.5% for 18 months means after 18 months you will receive a rate of 1% AER.

8. GROSS & NET

Interest rates for savings are always given BEFORE tax. This is called GROSS (it’s the same term used for your salary before any deductions). So what you actually earn depends on your tax rate and is called the NET rate.

Banks assume you are a basic tax rate payer and you are taxed 20%. This means for 5% interest on £1000 you actually get 4% (£40). For 2014/15 ‘basic’ means you earn between £10,000 and £41,865 per year Gross. If you earn less or more, you need to let your bank know.

9. IT GOES UP & DOWN

Unless you have a fixed rate (normally the case with credit cards), rates could go up or down. This is called a variable rate. Some accounts might offer bonus rates which expire, so keep an eye on terms and conditions.
Main Photo Credit: Images_of_Money via Compfight cc

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