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Interest

11th May 2022

By Ben Walker

Interest comes in lots of forms, whether it’s costing you money or earning you money. This guide will cover the different types of interest, and what you can do to find better interest rates. Finding the best interest rate for you could end up saving you a lot of money in the long run! 

Interest is a payment made as a percentage of a sum of money, whether that is money lent or money in a savings account.

The interest rate that you would be offered on your loans or savings can depend on a few factors. But a major contributor that affects rates is the Bank of England. They decide the ‘Bank Rate’. This rate is so important because it affects the rate that building societies high street lenders can borrow money at. 

An example of this was in 2020, when the Bank of England reduced the ‘Bank Rate’ by 0.1%. This meant that lenders could lend at lower rates, saving borrowers money. However, this had an additional effect of some banks lowering the rates offered on savings accounts. This resulted in less money being paid into these accounts.

However, it is very important to remember that each lender or banking institution sets their own interest rates. So if you base all your investment plans on the Bank Rate, you are likely to end up worse off than expected.

Simple Interest

When borrowing money, some lenders may offer simple interest (SI) on the principal sum (the money you borrow). This means that you will only pay interest on the money you borrow. This can be easily worked out as: 

Principal sum X interest rate X time.

So if you borrow £100,000 at a 5% interest rate over 25 years, the entire loan would cost you £225,000, or an extra £125,000. This is a massive amount of money. 

Compound Interest

Compound interest (CI) is the concept of paying or earning interest on the original sum of money, as well as previous interest once it’s applied.

So, if you deposit £100 in an account with 5% interest per annum, your first annual interest payment would be £5. This would leave you with £105 in the account. CI would mean that you then earn interest on the £105, instead of the original sum of £100. So, the next time you earn CI, your balance would be £110.25. Additionally, you would keep earning on the extra payments for as long as you are saving. 

When it comes to debt, CI could end up costing you a lot of money too. As most mortgages are fairly long term, this gives the interest time to build up. So, if you borrow £100,000, you may think you only have to pay back £100,000. This isn’t the case, as with an interest rate of 5% over a term of 25 years, you would end up paying £175,377.01. This means you are paying an extra £75,377.01.

Simple interest vs Compound interest

It’s very hard to say whether one type is better than the other. It completely depends on the situation. For example, if you’re opening a savings account, it is better to have CI. This is because the payments on previous interest would allow your savings to grow faster. 

When it comes to borrowing, it depends what you want from your loan. If it is a short term loan and you want easy to work out payments, SI may work better for you. But, if it’s a long term loan, CI may be better as you could end up paying less.

Saving

If you have a bank account that pays interest, such as a savings account, then your interest rate will determine how much money the bank or building society will pay into your account. The higher your rate, the more money you’ll receive in your payments. When opening a savings account, it’s always worth checking around for the best rate to make sure your money is working for you. It can’t hurt to go online and see what all the high street banks and building societies are offering. Some lenders offer quite decent interest rates on the first £1,000 or so to tempt you in. However you should consider the blended rate you are likely to have on all of your savings. For more information about the best type of bank account for you, check the Accounts page.

Borrowing

Interest when you are borrowing money can be displayed as Annual Percentage Rate (APR). When you borrow money from a banking institution, you will normally have to repay it over a set period of time. As you are repaying the loan, you will have to pay interest on top of the regular repayments.

This means that taking out a loan will end up costing you a lot more in the long run. 

Also because at the start of the loan you are paying mostly interest, the balance doesn’t come down very quickly. As you are approaching the end of the loan term more of your payment goes toward paying off the balance so it feels like you are paying it off faster. This is because the balance has reduced so less of your payment is needed to service the interest charges – more can be used to reduce the loan.

The type of interest you have on the loan will also have an impact on how much it will cost you. When you are borrowing money, make sure you read the fine print and know exactly what you’re getting into. Also watch out for early repayment charges. Some finance agreements are not easy to cancel so you could end up having to pay for the whole term – this is particularly the case if you take out agreements for your business – such as leasing equipment.

Borrowing money is a massive responsibility, and not being able to keep up with repayments could have big knock-on effects in your life – especially if you get into difficulty. Maintaining a good credit history is very important. 

When you’re trying to find a secured loan or mortgage, the best course of action would be to speak to a mortgage broker. They can help you find a loan with the best terms and interest rates for your circumstances. If you still aren’t sure about taking out a loan, there are steps you could take to get better terms. For example, your credit score can have a big effect on what loan offers you could get. Watch the Credit Score video to find out more.

When you are looking for a loan or to open a savings account, shop around! Don’t be afraid to ask for advice and learn as much as you can. When it comes down to it, it’s about making your money work for you and if you are borrowing, doing it responsibly and as cheaply as possible. Finding the best offer can end up saving you, or making you, a lot of money.


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