What are interest rates, and how do they work?
If you want to save or borrow money, your search for a good deal is likely to focus on one number: the interest rate. But what are interest rates, and how do they work?
We know that interest itself is simple enough: it’s a fee you pay to borrow, and a reward you get for saving. Interest rates, on the other hand, can get complicated.
In this guide, we’ll explain what interest rates are, how they’re calculated, and how interest works when you save and borrow.
What are interest rates?
An interest rate is the amount a financial institution charges you to borrow money, or that it pays you when you save.
Interest rates are usually shown as a percentage of the amount you’ve borrowed or saved – or of the debt that remains outstanding.
How do interest rates work?
Whether you borrow or save for yourself or your business, interest rates have a real impact on your day-to-day finances and financial planning.
Let’s define some key interest rate terms so you know how your interest rate is calculated, and feel better equipped to spot a good deal.
The Bank Rate
Set by the Bank of England, the Bank Rate of interest determines how much commercial banks themselves earn on their deposits.
From your bank’s point of view, everything starts with the Bank Rate – also known as the ‘base rate’ or the ‘Bank of England base rate’.
When the Bank Rate goes up, banks earn more from interest. As a result, they may ‘pass on’ these gains by offering you higher rates to save and lower rates to borrow.
But if the Bank Rate falls and banks earn less from their deposits, you’ll likely encounter higher borrowing costs – and lower saving rewards.
Factors that affect your interest rate for borrowing
The Bank Rate isn’t the only factor that influences your cost of borrowing. How likely you are to repay the debt is also crucial.
When you apply for credit as an individual, the lender checks your financial history and credit score. They’ll check your business credit score too, if you’re borrowing for your business.
If the credit score and reports are good, you’re more likely to receive a lower interest rate. But if the lender considers you a high risk, they may still lend to you – just probably at a higher rate of interest.
APR
APR stands for annual percentage rate, and it applies to borrowing. Lenders calculate APR by combining the loan interest rate with their fees and charges to show your total cost of borrowing as a yearly rate.
AER
AER stands for annual equivalent rate, and it applies to saving. AER combines the standard interest rate for the account with the effects of compounding to show the total rate of interest you will earn each year. However, any applicable fees or charges are not factored into AER.
We’ll go into more detail on compounding below (with examples).
Gross interest vs net interest
Gross interest is the annual rate you earn from savings before you pay any tax, fees or charges. Net interest is the effective rate after these deductions are factored in. You can think of gross interest as ‘revenue’ and net interest as ‘profit’.
Simple interest
Similar to gross interest, simple interest shows how much annual interest you’ll owe or earn when only the interest rate and the original saving/borrowing amount are factored in – it takes no account of fees or compounding.
Here’s how simple interest works:
Example
You put £500 into a business savings account with a 4% annual interest rate. One year later, you’ll earn £20 in interest.
You take out a £5,000 business loan with a 12% annual interest rate. One year later, you’ll owe a total of £5,600.
In practice, things are often a lot more complicated than this thanks to something called compound interest.
How compound interest works
Compound interest is interest you earn, or owe, on interest you’ve already accumulated on your savings or debt.
‘Compounding’ typically happens monthly, quarterly or annually and it can significantly increase the cost of borrowing or rewards of saving over time.
Here’s how compound interest works:
Example
In the simple interest example above, you earned £20 in interest after one year. If you leave your savings untouched, the next two years look like this:
- End of year 2: earn another £20 interest on the initial £500 deposit, taking your total to £540.
- End of year 3: earn another £20 interest on the initial £500, taking your total to £560.
But here’s what would happen with annual compound interest:
- End of year 1: earn £20 in interest, taking your total to £520.
- End of year 2: earn another £20 on the initial £500 deposit, plus 4% on the £20 interest earned in year 1 (£0.80) – taking your total to £540.80.
- End of year 3: earn another £20 interest on the initial £500, plus 4% on the £40.80 interest earned in years 1 and 2 (£1.63) – taking your total to £562.43.
An extra £2.43 after three years might not seem like much. But when higher sums, longer terms and more frequent compounding are involved, they can make a huge difference to the amount you save – or owe.
Aside from compounding, the main factor in how much you eventually repay or save is whether you have a fixed or variable interest rate.
Fixed vs variable interest rates
Fixed interest rates stay the same during the lifetime of your borrowing or saving – except where a temporary ‘fixed period’ has been advertised.
Lenders and banks often offer attractive fixed rates for an introductory period only. Many customers switch before that period ends – or transfer their balance to a new provider entirely – to avoid moving onto a less favourable rate.
Variable interest rates rise and fall as the economy fluctuates – eg. with changes in the Bank Rate of interest or inflation.
Here are some of the pros and cons of each type:
| Fixed Interest | Variable Interest | |
|---|---|---|
| Pros | – Exact costs of borrowing / rewards of saving can be calculated – Protection from any sudden downturns in the wider economy | – Economic improvements can have a positive effect on your debt or savings value – Early debt repayment without incurring fees may be possible |
| Cons | – No benefit from any improvements in the wider economy – Less favourable rates typically follow any promotional period | – Unfavourable economic shifts can leave you owing more or saving less – Difficult to predict exactly how much you’ll repay or save |
How does interest work on a savings account?
When you deposit money into a savings account, you start to earn interest at either a fixed or variable rate – depending on the terms you agreed to.
Your interest rate will be displayed as AER, unless you’ve signed up for a simple interest rate (although these are far less common).
You may earn interest on your account balance each day, but your interest payments are likely to arrive on a monthly, quarterly or annual basis.
How much interest you earn will depend on your interest rate, the amount you deposit, and how long you leave your money in your account. Remember: there are limits on how much savings interest you can earn before you have to pay tax. Learn more in our guide to savings interest tax.
How does interest work when you borrow money?
When you take out a loan, you promise to repay the money at regular intervals over an agreed period of time – plus interest and any fees or charges.
Your interest rate is likely to be displayed as APR, which means lender fees and charges have been factored into your repayments.
These monthly repayments will fluctuate if you’re on a variable interest rate, but they’ll stay the same throughout the loan if your rate is fixed. But as a business owner, it isn’t just loans that are paid for with interest. You’ll encounter interest with most types of business credit, including asset finance and a merchant cash advance.
And as an individual, you’ll pay interest on personal loans, mortgages, credit card purchases and cash withdrawals, current account overdrafts – and more.
Wrapping up
We’ve covered a lot here. But hopefully you’ve got a better understanding of what interest rates are, and how they work when you save and borrow.
Saving for your business? The Tide Instant Saver business savings account pays 4.07% AER (variable) on unlimited balances until 31 March 2025.
