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Interest is a word that crops up a lot when we talk about money. It’s also a word that we should take the time to understand because it can have a big impact on what happens to our money.

Most of the time, we hear interest talked about in two different ways: as interest on savings and as interest on money we owe.

Interest on savings

When you put money into an account, the bank or building society that holds the account doesn’t just sit on the money. They use it to do other things so what you’re actually doing is lending your money to the bank or building society. In return for this, they make a payment to you for being able to use your money and they add this to the money you have in your account. This is called interest. How much interest you get depends on where you put your money and how long you save it for.  So if you are going to save some money in a bank or building society, it is always worth having a look around at the rates that are on offer before you start.

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Interest on borrowing

If you borrow money, the companies you borrow from usually expect you to pay them for lending you the money – because this is how they make their money and also because there is always some risk involved in lending people money. Out of the people you know, think about who you’d trust to pay you back if you lent them some money. Some would be sure to pay you back promptly while others would vanish forever, taking your money with them. Companies lending money face the same question so the amount of interest they charge can depend on how likely they think it is that you will repay them.

The extra money you pay back when you borrow money is called interest and because you have to pay interest as well as the original amount you borrowed, this means you end up paying back more money than the amount that you first borrowed.

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The role of the bank

So the job of a bank is to bring in money from savers and then to lend it out to borrowers.  The borrowers pay the bank interest in exchange for borrowing the money.  The bank keeps some of this interest to pay its own costs, for example the cost of running the bank and then pays the rest of the interest to the people who deposited money with the bank.

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Compound interest

If you’ve ever put money into a savings account, you’ll know that the amount of money you have grows on its own. And the longer you save it, the more it tends to grow. Likewise, if you’ve got debts, you’ll know that they too have a horrible habit of growing on their own and the longer you leave it before you pay them back, the more they spiral. The reason for this is compound interest and it works like this:

  • If you have savings, as well as earning interest on the initial money you put in the savings account, you also earn interest on your interest. And then you earn interest on the interest on the interest and so on…
  • Unfortunately, the same goes for debts. Interest gets added to the amount you first borrowed, which means you owe more money. And then interest gets added to this larger amount of money so the amount you owe keeps growing and this continues until you manage to pay everything back.

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Interest rates

One of the reasons that many of us find it so hard to get our heads round interest and what it does to our money is that interest isn’t charged or paid at a set rate. Instead, the interest rates that we have to pay or get paid can vary a lot and for many different reasons.

  • How we save money can have an impact on interest rates. If we agree to put our money into an account and not touch it for a year, we often get a higher rate of interest than if we save into an account that gives us instant access.
  • On borrowings, interest can get charged at very different rates depending on what we borrow and how. For example, we’re likely to get charged more interest if we borrow on a store card rather than arranging an overdraft with our bank and the interest charged on a short-term loan is usually higher than that charged on a long-term loan.
  • If we’ve borrowed money in the past and don’t have a very good track record of paying it back on time, we might get charged more interest to borrow the money, which means we’ll have to pay a higher interest rate than someone who has a good history of paying back money.
  • Interest rates can go up and down, which means that unless we have agreed to pay or get paid a fixed amount of interest, we might end up with different interests rates on our borrowings or savings as time goes on.

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Interest is usually talked about in percentages. This means that when we talk about how much interest we’re being charged on borowings, we usually talk about it as a percentage of the amount we’ve borrowed. For example, we may say we’ve borrowed £1,000 at an interest rate of 10%. This means that as well as paying back the original £1,000, we also need to pay back another 10% on top, which works out as £100. Unfortunately, working out how much interest you’ll be paying isn’t as easy as this because of the compound interest that we talked about above.

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What does APR mean?

If you’re borrowing money, you should come across the letters APR before too long. They stand for Annual Percentage Rate and anyone lending you money officially has to tell you by law what their APR is. They work this out by adding together the interest you’ll be charged per year plus any extra costs such as arrangement fees. The idea behind this is that they make it easier for you to compare the cost of borrowing. For example, one company might have an APR of 5% while another has one of 10%. (The lower the APR, the better.)

Our loan calculator can help you understand this.

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What does AER mean?

If you’re saving money, the letters you’ll come across are AER. This stands for Annual Equivalent Rate. This shows how much interest rate you’d get paid if you put some money into an account and left it there for a year. Again, using AERs, you can work out which bank or building society will help your savings grow faster. (The higher the AER, the better).

Our savings calculator can help you understand this.

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