Interest rate is this tiny percentage that you either pay on the amount of money you borrowed or the one you’re saving in a savings account. It is small, but don’t underestimate it! It can be a great tool in your personal finances.
- Interest on loans – have to pay to lender.
- Interest on savings – don’t need to pay anything, you get to keep the interest!
nominal interest rate
Nominal interest rate is the interest rate advertised, like the APR or AER, before including inflation.
Real interest rate
When you include inflation into account, it gets real!
Real rate = Nominal Interest Rate – Inflation Rate
e.g. Real rate = 2% – 1.19% = 0.81% – which is what your ‘purchasing power’ is.
This is the main reason why borrowing is better than saving.
Bank rate, or Bank of England rate, is ‘the interest rate’. It is an interest rate set up by the Bank of England, which impacts interest rates of the rest of banks and building societies (and other providers) around the UK.
Gross Interest rate
Gross rate is the interest that is headlined on the savings or borrowing product, such as APR or AER (read below).
Net Interest Rate
Net rate is the interest rate including tax.
Annual PERCENTAGE Rate
APR is interest rate combined with fees such as administration fees. It exists just to make it more confusing for you! Just kidding, APR is used for comparing different loans without worrying about comparing their fees separately.
While APR is an annual figure, sometimes lenders show you a monthly APR, which is an APR divided by 12. It looks so much smaller and so much more appealing from the first sight. But it is just a marketing strategy! Normally any loan with lower than 20% APR should be a reason for suspicion.
And, the APR figure is not always what you’ll actually be paying. Any loan will have a certain ‘scenario’ it will be working on, like take mortgages for example. The first year or so you pay pretty low APR, but then it jumps up a few percentages which you pay for the rest of the 20 years. So, many say that APR is pretty useless in this sense.
When there is a ‘representative APR’ used in a loan advert, it means that only a half of applicants will actually get that advertised APR.The other half will get a higher APR, so make sure you clarify that with your lender.
If you got certain insurance policies that help the lender trust you with their money more, it will make APR cheaper!
Effective Annual Rate
EAR is the interest rate you pay on overdrafts. It includes the interest rate you pay, how often you pay and compounding effects of holding your overdraft for a year.
How to calculate interest you’ll be paying on a loan?
Before I show you how to use a very simple maths calculation for this, I want to clarify that the interest rate (that is in percentages) is what you’re usually given. So, what we are calculating here is the money you’ll need to pay on the money borrowed – and we call that ‘interest’ (not ‘interest rate’) .
So, let’s say you’re calculating a loan with first year APR of 25%, and you’re borrowing £1,000.
Interest = £1,000 x 0.25 = £250 – you will be paying first year after borrowing your money.
£250/12 = £20.90 – you will be paying monthly.
Compound interest is the interest you pay (or gain if you are saving) on the interest previously paid (or gained). Which means that after a couple of years your debt can become increasingly more difficult to handle. It is one of the main reasons for unmanageable debt that so many people fall pray to. However, if you got compound interest on your savings, then you’re in for some great benefits.
So, lets say that you’ll save that £1,000 instead of borrowing. Here is how your savings would grow if the interest rate would be 0.5%, 1% and 2%.
Annual equivalent rate
And, just like borrowing has APR, savings accounts have AER – Annual Equivalent Rate. This is the interest rate you get in one year of saving your money in that account. But, even if your account is set up to compound every couple of months or even every month, the AER only shows the interest you would compound if it was compounding on yearly basis.
Annual Percentage Yield
APY is another interest rate to compare savings accounts. But this time, it includes the power of compounding. So, basically APY is the interest you get on your savings including compounding. It is usually bigger than AER, and is more accurate.
Fixed interest rate
When your interest is fixed, it means that you’ll pay or get paid the same interest every year. For example, if APR is 7%, then no matter what happens, you will be paying 7% following year too.
Variable interest rate
When your interest is variable, it means that it depends on the bank rate. For example, if the Bank of England will reduce the base rate to 1%, but previously your interest was 2%, then your interest will drop to 1%.
Thank you for reading this post, I’ll be back to you with more money wisdom’s for artists tomorrow!
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