Whenever you are dealing with a financial matter, the concept of ‘interest rates’ is never far away. If you’re borrowing money, then you’ll need to know what interest you will be charged on your loan. If you’re saving money, you want to know what return you will get on your savings.
So, what are interest rates? And how do they affect saving and borrowing? Our guide tells you everything you need to know about interest rates.
What are interest rates?
Interest is:
- The return your bank or building society will pay you when you deposit your money with them
- The cost of borrowing money typically expressed as an annual percentage of the loan
Interest rates are linked – at least in principle – to the Bank of England Base rate. This is the rate at which the Bank of England charges banks and building societies to borrow money, and in August 2017 it stands at 0.25%.
The Bank of England Base rate can influence the rates set by financial institutions. If the Base rate rises, lenders increase their rates as it costs them more to borrow.
Similarly, if the Bank of England raises rates, banks and building societies will increase savings rates as your savings provider has effectively borrowed your money.
Interest rates for savers
When you save money with a bank or building society, you will usually earn interest on your cash.
This is because your savings provider takes the money you deposit and uses it to make more money. They will invest the funds by lending to other customers (through mortgages, personal loans, and credit cards, for example) or investing in other ways.
Here’s an example: if you place £5,000 in a savings account earning 2% interest annually, you will receive £100 in interest, giving you £5,100 at the end of the first year.
Interest rates on savings can change for a variety of reasons. They may go up and down depending on the Bank of England base rate of interest, and they may also vary based on the type of account you have. For example, if you’re prepared to commit your money to your bank for a defined period of time, you may receive a higher rate of return.
Interest rates for borrowers
When you borrow money, a lender charges you for this privilege. They are taking a risk when they lend you the money – they don’t know whether they will get it back – and so they want compensation.
Generally speaking, the lower the risk you represent (and the more likely the lender will get their money back), the lower the interest charge will be.
When you borrow money, you pay back the original amount loaned (called the ‘capital’) plus the interest.
For example, you borrow £5,000 from a bank. If your loan attracts an annual interest rate of 10%, you will have to pay back £5,000 plus 10% interest (£500). So, £5,500 is the amount you will have to pay back after one year.
The total could be more or less if you borrow the money over a longer or shorter period.
Fixed or variable rates
Whether you’re saving or borrowing, you will have a choice between two types of interest rate.
Fixed interest rates guarantee that you will earn, or pay, a specified interest rate for a specific period. These are common on mortgages, where your repayments are fixed at a certain amount for a number of years, and on some savings products, such as long-term bonds.
Irrespective of what happens to the Bank of England Base rate, your fixed rate won’t change.
Variable rates can change at any time. Many are linked to the Bank of England Base rate, while others can be raised or lowered at will by a financial institution.
If you want the security of knowing that you are going to pay – or earn – a guaranteed rate of interest, then a fixed rate may be for you.
If you want to take advantage of the flexibility of a variable rate and benefit if interest rates were to rise (for savers) or fall (for borrowers), then a variable rate may be better.
