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.
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.
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.
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.
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.
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.
Percentages
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.
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.)
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).
