What are interest rates?
There’s no such thing as free money. If you borrow money, the lender will ask for a bit more back than you borrowed. The bit more is the interest rate, calculated as a percentage of the original sum.
Likewise, if you give your money to a savings or investment provider you can expect an interest rate back in return.
Where have you heard about interest rates?
You’ll hear about interest rates whenever you’re looking to borrow or save money.
Central banks use interest rates to influence monetary policy, especially to control inflation, and their decisions are closely followed.
What you need to know about interest rates...
There are different types of interest rate. The base rate is the rate at which banks can borrow money from the central bank. Commercial banks are influenced by this, but can set their own interest rates for savers and for lending.
The simple, or nominal interest rate is based on the original amount that is borrowed or saved:
Simple interest = principal x annual interest rate x years
For instance, if you saved a principal of $1,000 at a simple annual interest rate of 7% for 2 years you would earn $140 interest in total, or $70 a year.
With a compound interest rate, the interest is worked out each year as a percentage of the principal plus any accrued interest:
Compound interest = (principal + accrued interest) x annual interest rate
So, in the example above, but with a compound interest rate, you would earn $70 in interest in the first year and then $79.80 in the second year, because you’re also earning interest on the $70 interest you got in the first year.
Interest rates can also be fixed or variable.
When borrowing, you’ll often see interest rates expressed as an Annual Percentage Rate (APR) or Effective Annual Rate (EAR). When saving, interest rates are often expressed as Annual Equivalent Rate (AER).