Understanding Interest Rates

Basic maths still baffles a lot of people, but it is important that you can understand how basic interest rates work, as all loans that you take will charge some kind of fee. That fee determines whether you can actually afford the loan or not. Don't just let your financial adviser tell you, though they are regulated and should be looking after your interests, you do need to understand what it all means. Now some interest calculations get very complicated but if you can atleast understand the basics, you will get by.

Below is an extract from Money Saving Expert the complete tutorial can be found here.

The interest rate you pay to borrow

If you borrow money at a 5% interest rate for a year, it will cost you 5% of the amount borrowed to do so. This will need to be repaid along with the original money you borrowed. Interest rates are usually quoted annually, but not always, so make sure you check.

An example to clarify

How much does it cost to borrow £1,000 at 10% then repay it six months later?

Let's start with a simple sum. One year at 10% would cost you £100 (10% of £1,000). So over six months you'd pay about half that, ie, £50. It really is almost as simple as that.

The reason I say ‘almost' is it isn't exactly half of that, due to compound interest (see below). However, this is a good rule-of-thumb way to think about it.

The interest rate when saving or in credit

This works in exactly the same way, and there's a simple reason why. When you are in credit or saving with a bank, you are effectively lending it your money to do with as it pleases until you want it back.

Therefore the savings rate is what the bank pays you for borrowing your money.

An example with savings

How much will you make by saving £1k at 5% for nine months?

Another simple sum to start. If you saved this for a year, you'd earn £50 (5% of £1,000), but as you've only got the money there for nine months you'd actually get around three quarters of this, which is £37.50. Again this isn't exact due to compound interest.

See the Top Savings guide for more information.

The thorny issue of tax and interest

Thankfully there's no tax on borrowing money, you simply pay back what you owe and the government doesn't get its hands on it.

Yet when you earn money from savings the interest earned counts as ‘income', so you have to pay income tax on it. The amount you pay depends on how much you earn in total – adding up employment and savings income.

Read the rest at Martin's site

Other resources

Interest rates for dummies
Points and Interest rates
Choosing between a Fixed- and Adjusted-Rate Mortgage

About the Author

Andrew Eagle has worked in the Finance Industry for over 26 years, currently specialising in bridging loans. He regularly contributes to blogs on bridging finance. Find him on Google +

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