What is an interest rate?

Interest could be paid to you when you save money or be a cost when you borrow. When you borrow money, whether that's in the form of a mortgage, credit card, personal loan, overdraft or car finance, you may need to pay a percentage of interest - essentially, a charge for borrowing money.

Interest when you borrow

Interest on borrowing is a cost. 

When you borrow for things like a mortgage, a credit card, or a personal loan, you may also have to pay back a percentage of interest. Borrowing could include other fees and charges, as well as the amount of money you want to borrow. 

Interest when you save

Interest on saving is a reward. 

When you save money, your bank or other financial institution may pay you a percentage of interest. This is usually paid either monthly or yearly. 
 

How do interest rates work?

Not all interest rates are the same. In fact, there are a few different types. Here are some of the most common:

The Base Rate

Also known as the ‘Bank Rate’ and the ‘Bank of England Base Rate’. It’s set by the Monetary Policy Committee, who work with the government to help manage inflation and the economy. 

This is the interest rate to be paid to commercial banks, and it then impacts the interest rates offered to customers who may have borrowing or savings that are linked to the Bank Of England Base Rate.

So, if the Base Rate goes up, your earnings from savings may go up. And your interest costs may go up, unless your interest rates are fixed. 

And, if the Base Rate goes down, your interest earned on savings will go down. And, the cost of borrowing may also go down. 

Try the Base Rate calculator

Simple interest

As the name suggests, it’s a straight-up calculation of potential interest only. No fees, charges, payments or withdrawals are taken into consideration – just the borrowing amount.  

Here are some examples: 

  • £1,000 borrowed at an annual interest rate of 12.5% means that, after a year, you would owe £1,125. 
  • £1,000 saved at an annual interest rate of 3.5% would earn you £35 after one year. 

Compound interest

Compound interest is a bit more complicated. It includes interest earned or charged over time, not just the borrowing amount. Over time, compound interest could make a big difference to your savings or borrowing costs. 

Here’s an example of compound interest on borrowing and savings of 2.5% a year:

Compound interest example

Year

Balance    

Interest per year

Closing balance

Year

1

Balance    

£1,000

Interest per year

£25

Closing balance

£1,025

Year

2

Balance    

£1,025

Interest per year

£25.63

Closing balance

£1,050.63

Year

3

Balance    

£1,050.63

Interest per year

£26.26

Closing balance

£1,076.89    

This example assumes that no money has been deposited into the account or removed.

Fixed-rate interest

A fixed-rate of interest is set for a period of time and is not impacted by changes to the Bank Rate.

Loans are often offered at a fixed-rate for a term, and other borrowing could be offered at a fixed-rate for an introductory or promotional period of time.

A fixed-rate helps to manage regular payments, so you know what’s coming out every month. While, the fixed rate ensures that your interest won’t go up if the Base Rate goes up, it also means that rates won’t change if the Base Rate goes down. 

Variable-rate interest

A variable rate goes up and down over time and could be impacted by changes to the Base Rate. You may see variable rates offered on all kinds of financial products, from mortgages and savings to loans and credit cards.

When market interest rates are low, borrowing costs may be lower and earnings on savings will also be lower. 

Other fees and charges

When it comes to borrowing, it’s not just interest you may be charged. There may be other fees and charges to consider. And, remember you may need to pay income tax on certain earnings from savings and investments.

What does APR mean?

APR stands for Annual Percentage Rate. An APR can help you see how much it will cost you to borrow money. 

It gives you a picture of how much interest, including other fees and charges, you may pay over a year and can help when comparing your borrowing options.

What does AER mean?

AER stands for Annual Equivalent Rate. An AER can help you see how much interest you could earn on savings. 

It includes how your savings interest accumulates over a year and can help you to compare different savings accounts.

Promotional interest rates

Some lenders will offer promotional rates for the term or for an introductory period. For example, 0% interest rates on credit cards. 

It’s important to check when the promotional period ends and any terms and conditions that come with the borrowing. 

As an example: Say a credit card offered 0% interest for a year on balance transfers made within 90 days of opening the account. If the credit card isn’t used for anything else, then no interest would be charged for those 12 months. 

Don’t forget, there may be transfer fees, which are usually a percentage of the amount transferred.  If that credit card was used for purchases, then interest may be charged as the 0% interest only applied to the balance transferred, and only for 12 months. In order to keep promotional rates for the introductory period and avoid additional fees and charges, you need to stay within your credit limit and make at least your minimum payment on time each month.

On the transactions pages of your PDF or paper statement, you will see a breakdown of your balance and the interest rates that apply.  If any of your balance has a promotional interest rate the expiry dates will also be shown there. 

How do lenders choose an interest rate?

There could be a set interest rate or lenders may consider a number of factors to decide an interest rate. They may look at your borrowing history, your affordability, your credit score and your personal details, for example.

What is a credit check

Different credit types can mean different interest…

How interest works with a current account

Interest you earn on a current or savings account it may be on a fixed or variable interest rate. 

Say you had an annual interest rate on your savings account. If you kept £1,000 in a savings account over a year, then the interest you’d receive would be calculated on the balance of £1,000. 

Don’t forget any earnings from savings over your personal allowance may be subject to income tax.

Some current accounts come with arranged overdrafts, and you could be charged interest for using an arranged or unarranged overdraft.

How interest works with a mortgage

Interest on a mortgage is calculated as a percentage of the overall balance. 

Repayment mortgages mean you're paying monthly instalments that cover both interest and capital over the course of a term. So, you will pay off the amount you have borrowed over time, plus the interest and any other charges. An interest-only mortgage will only pay the interest each month and not the capital, so the full amount will be required at the end of the term. 

A mortgage can be fixed rate or variable:

Fixed-rate mortgages mean paying the same amount every month until the end of the fixed rate period. 

Variable-rate mortgages mean the amount you pay each month could go up or down, depending on interest rates. 

How interest works with a personal loan

A personal loan allows you to borrow an amount of money over a period of time. As long as you’ve made all of the agreed payments over that time (or ‘term’), then the balance will be paid off. 

Loans can have fixed or variable interest rates. The interest rates are included in monthly repayments. If the interest rate is fixed, then the repayments will be fixed too.  

Some loans have overpayment terms and fees. So, it’s worth checking over your agreement if you want to pay more per month or repay a loan before the end of the term.  

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How interest works with a credit card

Credit cards all have different interest rates, and the rates could be different for different transaction types. For example, a credit card could offer 0% interest on balance transfers but charges 4.5% on purchases.   

When introductory and promotional rates apply, you might consider clearing the balance by the time these offers expire to avoid paying more interest. 

Before agreeing to take out a credit card, get clear on the fees and charges that come with it. 

Compare credit cards

A quick recap

Here’s what you’ve learnt about interest rates:
 

  • Interest can earn you money on your savings, and cost you money when you borrow. 
  • The Bank of England Base Rate can influence the interest rates available for both savings and borrowing. 
  • There are both fixed and variable interest rates. Fixed rates are not impacted by changes to the Base Rate. Variable rates can go up and down. 
  • Interest rates are different for different credit types, and there may be other fees and charges to consider. 

Keep reading

Applying for credit

How does a credit score work?
What is a bad credit score?
What is a good credit score?
Why has my credit score gone down?
What affects your credit score?

Using credit

How to consolidate debt
What is APR?
What is a balance transfer?
What is a money transfer?

Ways to borrow

What is credit?
Credit cards
Loans
Knowing what you can afford
How a credit card works

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