Don't borrow money until you fully understand the details of what interest is! Otherwise, you could end up in a mountain of unexpected debt.

Interest can be a confusing topic to grasp, so we're here to break it down for you.

What's interest, and how does it work in 2025?

Our goal at SovereignBoss is to ensure that you leave our site with a better understanding to navigate your personal finances with confidence.

Therefore, we have spent hours studying the various interest rate options available in the UK in 2025.

Here's what you must know:

An Introduction to Interest Rates

Interest is a charge by a lender to a borrower for the usage of assets. The interest charged is the difference between the total repayment amount and the original loan.

Most lending or borrowing transactions are subject to interest rates.

While cash purchases are always a better and less expensive option, the reality is that most individuals need to borrow money¹ from time to time.

This could be to purchase big-ticket items like a house, fund a project, start or expand a business, or pay for college.

In addition, it's not uncommon for businesses to take out loans to fund big projects or a start-up.

The amount charged is usually based on a percentage of the total loan amount. The interest on a loan is usually charged annually. This is known as an annual percentage rate (APR).

The term interest rate can also be used to refer to the money deducted for income by a bank or credit union from a savings account or certificate of deposit.

This is known as an annual percentage yield (APY).²

How Do Interest Rates Work?

Interest rates work by adding a fee to the borrowed money until the total amount is paid back, either in a lump sum or in regular instalments over a set period.

The interest rate will generally be less if the lender is confident in a borrower's ability to repay.

If the borrower is considered high risk, the interest rate they are charged will be higher, resulting in a greater overall loan cost.

An Example of an Interest Rate

If you opt for a £400,000 mortgage loan from your bank and there's a loan agreement of 3.5%, you'll be entitled to pay the bank the original loan amount and the interest.

The sum: £400,000 + (3.5% x £400,000) = £400,000 + £14,000 = £414,000.

But, there are 2 different types of interest, simple interest³ and compound interest, which will impact the total differently.

*These figures are for indicative purposes only.

What Are Simple Interest Rates?

The above is an example of a calculation based on the formula used to determine annual simple interest.

With simple interest, the bank is owed that amount of interest annually. As per the example above, the borrower must pay £14,000 in interest each year.

However, if the loan period is more than a year, the calculation with simple interest will be different.

Here's an example with a 20 year loan:

£400,000 X 5.85% X 20 = $468,000 in interest*

The yearly interest rate⁴ of 5.85% implies a yearly interest cost of £23,400.

The borrower would have made a total of $468,000 in interest payments over 20 years, demonstrating how banks generate their profit.

*These figures are for indicative purposes only.

What's Compound Interest?

Compound interest, which is said to have originated in Babylon⁵, is "interest on interest" and will cause a sum to grow quicker than simple interest, which is computed just on the principal amount.

Compound interest accrues at a rate determined by compounding frequency. The higher the number of compounding periods, the higher the compound interest rate.

As per the example above, after 20 years, the interest owed on a £400,000 at a 5.85% interest rate would be almost £900,000, doubling the initial loan amount.

Here's the formula:

Compound interest = p X [(1 + interest rate)ⁿ − 1]
where:
p = principal
n = number of compounding periods​

Note that equity release mortgages work with compound interest. You can reduce the loan amount by making monthly contributions.

Understanding Compound Interest & Savings Accounts

If you want to grow your finances by investing money into a savings account⁶, compound interest is always preferable as your investment will grow faster.

Here's an example:

If you put £500,000 into a high-yield savings account and receive interest of 1% each year, the bank may use £300,000 of your money to provide a mortgage loan.

To reimburse you, the bank pays enough interest into the account to earn 1% yearly. The bank takes 4% from the borrower and gives 1% to the account holder, resulting in a 3% profit.

In reality, savers loan money to the bank, who then lends funds to borrowers in exchange for interest.

These figures are for indicative purposes only.

Borrower's Cost of Debt

While interest is a means for the lender to profit, it often comes at a hefty cost for the borrower.

To figure out which source of finance will be the most cost-effective, companies compare the expense of debt to that of equity.⁷

The cost of capital is compared to establish an optimal capital structure since most firms finance their resources by taking on debt or issuing stock.

APR vs. APY Interest

The annual percentage rate (APR)⁸ is the interest rate used to compute the cost of credit on consumer loans.

This is the amount lenders will expect in return for giving you a loan. APR interest rates do not use compound interest.

The annual percentage yield (APY)⁹ is the interest rate earned on a savings account or CD at a bank or credit union. This interest rate includes compounding.

How Do Lenders Determine Interest Rates?

The Bank of England (BoE)¹⁰ determines the UK's bank rate or 'base rate.' It can potentially influence interest rates set by financial entities like banks.

As borrowing costs increase, lenders are likely to want to charge more if the base rate rises.

The same principle applies to savers. If the Bank of England's base rate rises, the interest you earn on your savings should also climb. This is because your savings provider has effectively borrowed your money.

The Average Mortgage Interest Rates in Sep 2025?

According to statistics, the average mortgage interest rate in the UK is currently sitting at 6.3%.¹¹

Interestingly, the average interest rate between 1971 to 2022 was 7.21%, reaching an all-time high of 17% in November of 1979.¹²

Common Questions

In Conclusion

If you're interested in borrowing money, be sure to research the different types of loans available and understand all the costs involved.

There are many loan options for those looking for a way to borrow money.

Be sure to compare not only interest rates but also other fees associated with these loans before making any decisions on which one is right for you.

In addition to being sure you understand what is interest, we always advise that you get in touch with a financial adviser to guide you through all your money-related decisions.