Understanding Interest

What's Interest?

Why Is Interest So Important in Finance? How Does It Affect the Loans That You Take? We'll Discuss Them Today and Help You Get an Insight Why Interest Is Very Relevant to Today's Market.

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What’s Interest?

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

With statistically over half of Britain not knowing what interest means, we are here to break it down for you. So, what is interest, and how does it work in 2022?

This article will help you discover:

  • The different types of interest rates.
  • The formulas used to calculate interest.
  • How interest rates you can achieve are determined.

Our goal at EveryInvestor is to ensure that you leave our site fully equipped to navigate your personal finances far more confidently.

Therefore, we have spent hours studying the various interest rate options available in the UK in 2022.

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 money from time to this.

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 union1 from a savings account or certificate of deposit.

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

How Do Interest Rates Work?

Interest works with the borrowed money and additional fees being paid back either in a lump sum or in regular installments over a set period.

The interest rate will generally be reduced when 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 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 will 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 interest, and compound interest, which will impact the total differently.

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 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 3.5% X 20 = $280,000 in interest

The yearly interest rate of 3.5% implies a yearly interest cost of £14,000.

The borrower would have made a total of $280,000 in interest payments over 20 years, demonstrating how banks generate their profit.

What’s Compound Interest?

Compound interest, which is said to have originated in 17th-century Italy, 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, with 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 3.5% interest rate would be almost £800,000, 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 account, 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, lending funds to borrowers in exchange for interest.

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.2

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) 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) 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)3 determines the UK’s bank rate or ‘base rate.’ It can potentially influence interest rates set by financial entities like banks.

As borrowing costs rise, 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 Jun 2022?

According to statistics4, the average mortgage interest rate in the UK is currently sitting at 2.6%.

Interestingly, The average interest rate between 1971 to 2021 is 7.21%, reaching an all-time high of 17% in November of 1979.

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, we always advise that you get in touch with a financial adviser to guide you through all your money-related decisions.

Editorial Note: This content has been independently collected by the SovereignBoss advisor team and is offered on a non-advised basis. Sovereignboss may earn a commission on sales made from partner links on this page, but that doesn’t affect our editors’ opinions or evaluations. Learn more about our editorial guidelines.

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