When you borrow money for anything from a mortgage to a credit card, the amount you pay back is dictated by the interest rate, plus any additional fees. The same goes for savings accounts where you can earn interest. Here’s how interest rates work.
What’s in this guide
What is an interest rate?
When you borrow money, interest is the cost of doing so and is typically expressed as an annual percentage of the loan (or amount of credit card borrowing).
When you save money it is the rate your bank or building society will pay you to borrow your money. The money you earn on your savings is also called interest.
Interest charged on a loan (or other borrowing)
When you borrow money, you’ll pay back the original amount loaned (called the ‘capital’) plus the interest.
Let’s say you borrow £1,000 from a bank:
If your loan attracts an annual interest rate of 10%, you will have to pay back £1,000 plus 10% interest (£100). So £1,100 is the amount you will have to pay back after one year.
The total might be different if you borrow the money over a longer or shorter period.
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Interest earned on savings
If you place £1,000 in a savings account earning 2% interest annually you will earn £20 in interest, giving you £1,020 after one year.
Again, the interest you earn could be different if the rate of interest changes or the balance within your savings account fluctuates during the period that the interest was calculated.
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How do interest rates work?
The Bank of England (BoE) sets the bank rate (or ‘base rate’) for the UK.
This can influence the interest rates set by financial institutions such as banks. If the base rate goes up, it’s likely lenders may want to charge more as the cost of borrowing increases.
This works in the same way for savers. If the BoE base rate rises you would expect to see the interest you earn from your savings to increase. This is because your savings provider has effectively borrowed your money from you.
What is APR?
When you borrow money, your lender will often advertise an ‘APR’ (Annual Percentage Rate). This is slightly different from the interest rate because it is made up of the interest rate plus any fees that are automatically included in your loan (for example, any arrangement fees).
The APR is particularly useful as it provides a benchmark when comparing similar financial products.
How does compound interest work?
Compound interest is calculated by adding interest to your loan or savings where interest has already been charged or included. This means that the added interest charged or earned from previous periods will also have been applied.
For example, let’s say you put £1,000 in a savings account earning 2% interest. After 12 months you’d have £1,020. The table shows how your savings would grow at different rates of interest, and the impact of compounding. The longer you save for, the greater the effect of compound interest.
| Term | 0.50% | 1% | 2% |
|---|---|---|---|
|
Year 1 |
£1,005 |
£1,010 |
£1,020 |
|
Year 2 |
£1,010 |
£1,020 |
£1,041 |
|
Year 3 |
£1,015 |
£1,030 |
£1,062 |
|
Year 4 |
£1,020 |
£1,041 |
£1,083 |
|
Year 5 |
£1,025 |
£1,051 |
£1,105 |
Tax on savings interest
If you’re a UK Taxpayer, you’ll probably have to pay Income Tax on the interest you earn on your savings. Having a Cash ISAs is probably the main exception to this rule.
But most UK adults have a personal savings allowance allowing them to earn up to £1,000 interest on their savings without paying tax if they’re a basic rate taxpayer. Higher rate taxpayers can earn £500 interest tax free.
