When you borrow money, 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 is interest rate?
When you borrow money, interest is the fee you pay for using it, usually shown as an annual percentage of the loan or credit card amount.
When you save money, the bank or building society is borrowing your money and pays you interest in return.
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.
You can find out what the current bank rate is on the Bank of England siteOpens in a new window
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 increase.
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.
Find out more about APRs at MoneySavingExpertOpens in a new window
How does compound interest work?
Compound interest means you earn interest both on your original amount and the interest that has already been added. This means the interest from previous periods is added to the total, and then you earn interest on this new larger amount.
The table shows how £1,000 in a savings account could grow at different interest rates, including the of interest, and the impact of compounding (figures are rounded for simplicity). The longer you save for, the more your savings will benefit from compound interest.
| Term | 2% | 3% | 4% |
|---|---|---|---|
|
Year 1 |
£1,020 |
£1,030 |
£1,040 |
|
Year 2 |
£1,041 |
£1,061 |
£1,082 |
|
Year 3 |
£1,062 |
£1,093 |
£1,125 |
|
Year 4 |
£1,083 |
£1,126 |
£1,170 |
|
Year 5 |
£1,104 |
£1,159 |
£1,217 |
Tax on savings interest
If you’re a UK taxpayer, you may have to pay Income Tax on the interest you earn on your savings, except for Cash ISAs.
Most UK adults have a personal savings allowance, letting basic rate taxpayers earn up to £1,000 in interest without paying tax, and higher rate taxpayers can earn £500 interest tax-free.
There’s also a starting rate for savings, up to £5,000. This means the first £5,000 of income from savings is tax-free, provided your total earned or pension income is below £17,570 for the current tax year. This allows some people to receive even more interest without paying tax.
