Understanding interest rates: How they affect your savings and loans

Interest is what you pay for borrowing and what you earn for saving. But who decides interest rates, what affects them, and how do they impact you? When you borrow on a credit card, mortgage or overdraft, you’ll often be charged interest. And if you squirrel away your savings you can earn interest on it. But how does it all work?

What are interest rates?

When it comes to explaining interest rates, a good place to start is the Bank of England. This is because they set the official ‘Bank Rate’ (or Base Rate) to help regulate inflation. In other words, they try to make sure the price of goods doesn't rise or fall too quickly. The ‘Bank Rate’ is then used by other financial institutions to set their commercial interest rates.

The higher the official ‘Bank Rate’, the higher commercial interest rates are likely to be. That means you’ll pay more to borrow, but you’ll also get bigger returns on your savings. In theory, this stops people from buying as much stuff, which means that the price of stuff rises more slowly. The stated aim is currently to keep inflation at around 2%.

Commercial interest rates impact the cost of your repayments when you borrow money. Even a shift of a couple of percent can make a big difference to your repayments, especially on a large loan like a mortgage. Equally, when you save money you’re essentially loaning it to the bank for them to invest. The bank therefore pays you an interest rate, although it is usually much lower.

If you’re wondering: “What is a good interest rate?” The answer comes down to whether you’re borrowing or saving. If you’re borrowing, you want the interest rate to be as low as possible, so you have less to repay. Whereas, if you’re saving it pays to have a higher interest rate, as you will earn more on your money. 

What are loan interest rates?

So, what is credit interest? Whenever you borrow money you’re of course expected to pay it back to your lender. But they also charge you interest on what you owe, so you ultimately pay back more than what was originally borrowed. The interest is where lenders make their money.

Let’s say you borrow £1,000 from a lender and they charge 10% annual interest. Within one year you’ll have to repay the initial £1,000 + 10% (£100). So your total repayment would be £1,100. The interest you’re charged can change based on how much you want to borrow, how long you want to repay it, and how risky the loan appears. 

Lenders consider your creditworthiness by checking your credit history on your credit report. You can check your creditworthiness using your credit score, which is calculated by credit reference agencies (CRAs). Higher credit scores often attract better interest rates, and better interest rates can save you £1,000s through the life of a mortgage.

For a fast and proven way of building your credit score, get started with Loqbox. For £2.50 per week, you can boost your credit score with the top three CRAs (Experian, Equifax and TransUnion). You can read more about how credit scores affect loans here.

Improvements to your credit score are not guaranteed. 

What is a good interest rate for a mortgage?

When buying a house, interest on mortgages can vary because you’ll hold the loan for many years, and the ‘Bank Rate’ can change a lot during that time. Mortgages usually come with either fixed or variable interest rates. 

So, what is mortgage interest and what do you need to know? The main question is: “What is fixed interest and what is a variable interest rate?” Fixed-rate mortgages lock your interest rate for a set duration. This means you pay the same regardless of what happens to interest rates in the Bank of England.

This is great if interest shoots up because you keep paying lower rates. But if rates drop, then you miss out on the savings. Variable rates can work in different ways, but ultimately they may give you more flexibility to jump on the best rates. It can be a gamble either way so it’s best to consider your own appetite for risk.  If in doubt, you can speak to an independent financial adviser. 

Interest on savings

Where interest on a loan is essentially a fee that you’re charged for the service, interest on savings is paid to you for lending your money to the bank. Banks often reward you for keeping more money with them, and for not touching it for longer periods.

When the Bank of England Base Rate increases, the interest paid on your savings typically rises as well. However, the Base Rate only serves as a guide for banks rather than setting the rates on particular savings or deposit accounts. When rates rise, you can often find better deals by opening new accounts.

One thing you might see when looking at savings interest is the AER (Annual Equivalent Rate). This is the interest rate that you can use when comparing different savings accounts. It takes into account things like compound interest (see below), fees and bonuses, to give you an idea of how much interest you will earn over a year.

Understanding interest rates

Have you ever wondered how interest rates impact your savings and loans? Let’s break down a few commonly asked questions so you can feel confident about your financial choices.

What is APR interest?

Lenders often advertise their financial products with an APR (Annual Percentage Rate). This rate is often different to a standard interest rate because it includes things like charges or fees relating to your loan. It gives you a more realistic idea of how much you will pay throughout your loan. This can be super useful when comparing loans or other products, such as credit cards.

Read more about how credit scores affect credit cards here.

How compound interest works

Compound interest relates to interest earned on savings that have already grown from interest. It’s basically interest on top of interest. This means, your savings can ‘snowball’ and grow larger. Interest on savings can be paid daily, monthly or annually. The more frequently the interest is paid, the faster your snowball will grow. 

How tax on interest works

UK Taxpayers usually pay Income Tax on any interest that you earn on your savings. However, some savings accounts are tax-free, such as  ISAs. Typically, you can earn up to £1,000 interest tax-free, whereas higher-rate taxpayers can only earn £500 tax-free.