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What is an interest rate?
Interest can be paid to you when you save, or be a cost to you when you borrow.
How do interest rates work?
There are different types of interest to get your head around:
|
Year |
Balance |
Annual interest |
Closing balance |
|---|---|---|---|
|
Year 1 |
Balance £1,000 |
Annual interest £25 |
Closing balance £1,025 |
|
Year 2 |
Balance £1,025 |
Annual interest £25.63 |
Closing balance £1,050.63 |
|
Year 3 |
Balance £1.050.63 |
Annual interest £26.26 |
Closing balance £1,076.89 |
This might not seem that significant, but over a number of years and as your balance changes, this could make a big difference to the interest you pay or earn.
Other fees and charges might apply
Annual or monthly account fees and other charges might apply to current and credit accounts. In addition, you may need to pay tax on any income from savings and investments.
Promotional interest rates
Many lenders offer fixed, low and even 0% interest rates on some credit products, which could help you to tackle your borrowing needs and limit costs.
These are often introductory or promotional offers, so make sure you check the terms and conditions to understand if and when interest rates expire.
Imagine you’re accepted for a credit card offering 0% interest for 12 months on balance transfers made within 90 days of account opening.
If you don’t use your credit card for anything else, and you repay your full balance by the end of that 12-month period, you won’t pay any interest at all. Just make sure you account for any transfer handling fees – usually a percentage of the transfer amount.
If you did go on to make purchases using your credit card, unless a 0% interest rate applies, to avoid paying interest on purchases, you need to pay off your statement balance in full and on time every month, including any transferred balances.
How interest works for each credit type
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The interest you earn from a current or savings account can either be fixed or variable. To check the rate, simply refer to your account terms and conditions.
Interest is paid on the balance you hold in your account, e.g. for a savings account which pays interest annually, if you have £1,000 in your account for 12 months, you’ll receive interest on that balance.
It’s worth knowing, if you’re a UK taxpayer, you might need to pay income tax on interest you earn above your personal savings allowance. An ISA could help you to manage your tax liability on savings.
An overdraft on a current account could be useful as a short-term safety net, helping you to manage unexpected costs, or simply tide you over for a few days.
Some banks and building societies will allow you to use an unarranged overdraft, but your credit score could be negatively impacted.
Instead, you could apply for an arranged overdraft online, over the phone or in branch. You’ll only be charged daily interest if you use it, as detailed in the terms and conditions of your account.
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With a personal loan you could borrow a fixed amount, over a term to suit your budget – commonly 1-7 years. At the end of the term, as long as you’ve made all of the required payments, your loan will be fully repaid. Interest is included in your monthly payment amount.
If interest rates are fixed your monthly loan repayments will be too, making it easy to understand your borrowing costs and where you stand with your loan.
If you choose a personal loan with variable interest rates, it’s useful to know that your monthly payments could change over time.
You might be able to make overpayments on some loans without facing early repayment charges, which could reduce the term and amount of interest you’ll pay. If you settle your loan in full before the end of the agreed term though, early repayment charges might apply.
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Interest is charged as a percentage of the money you borrow on a credit card, but the rates could be different for each transaction type.
One transaction type could have lower interest rates that all of the others, e.g. for balance transfers or purchases, essentially telling you what the card is best used for.
Introductory and promotional interest rates might apply, offering low or even 0% interest on qualifying transactions for a set period of time.
To limit your borrowing costs, you should aim to repay any balances on an introductory or promotional rate before the offer expires. After that the standard interest rates will apply, which are usually higher.
You could avoid paying any interest at all if you repay your balance in full every month.
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Mortgage interest is calculated as a percentage of your balance.
On interest-only mortgages your monthly payments could be lower, but the balance doesn’t reduce during the mortgage term, and you’ll need to repay the full amount at the end.
On repayment mortgages, you’ll pay more interest at the start, and less as you reduce your balance over the mortgage term.
Fixed rate mortgages
Many people prefer their mortgage payments to stay the same each month, so opt to fix their mortgage for anything from 2-10 years. Although you may not benefit if interest rates drop, you will be protected from increases in your borrowing costs.
At the end of the fixed rate term a variable rate will apply, so you might want to switch to a new mortgage deal as soon as your fixed rate ends, helping you to manage your borrowing costs, but avoid any early repayment charges.
Variable rate mortgages
If you’re happy with your monthly payment amount changing over time, a variable rate could bring down your borrowing costs while interest rates are low. If interest rates go up though, it’s important to know that your payments could increase too, which could put extra pressure on your finances.
A ‘tracker’ is one type of variable rate mortgage, typically following the Bank Rate.