Almost all financial transactions undertaken through a bank come with some form of interest. This interest can be favourable or unfavourable, depending on how you interact with the bank. The only constant is that interest plays a huge role in daily finances.
Understanding interest, however, is something few people worry about. Despite its effect on our finances, estimations are that most Brits don’t understand compound interest and that almost all Brits, aside from those in business, don’t understand effective annual rates.
If you’re among these groups, we’ve simplified things for you with this handy guide to explain the different types of interest and what you should look for. Having this knowledge can help you manage your finances and have more to spend on holidays, things around the house, or entertainment from casinos.com.
What Is Interest?
In its most basic form, interest is the cost of debt. As such, when you borrow money using a loan or credit card, you are charged interest as a cost of having borrowed this amount from your bank or institution.
Likewise, if you have savings in your account, your bank will often use this money and lend it to others. To compensate you for lending your money, the bank will pay you a portion of what they charge whoever borrows it and you will gain interest.
Therefore, interest is the cost of debt if you incur debt or the reward for savings if your money is used to grant debt to somebody else.
Types of Interest Rates
Various types of interest rates affect how interest is charged, how much can be charged, and how it is calculated. The most common of these are:
Base Rate
The base rate, set by the Bank of England, is the UK’s official interest rate. In other countries, it is also referred to as the prime lending rate, as it influences almost all other interest rates in a country. Contrary to popular belief, this rate is separate from that set by Her Majesty’s Revenue and Customs (HMRC) and is not impacted by interest rate changes within the HMRC.
Fixed Rate
A fixed interest rate is one that is set at a specific percentage over a timeframe and is not subject to change if the base rate or any other factors are changed. These are often preferred for things like mortgages as they provide a constant repayment amount, but because of this, they are often higher rates.
Variable Rate
In contrast to fixed rates, variable rates can be changed over the course of a loan to reflect changes to the base rate or due to other circumstances. Variable rates are often better but can become significantly more expensive if the base rate is raised.
Annual Percentage Rate (APR)
The APR is one of the most commonly referenced interest rates and is best suited to comparing different interest rates from various offers. This rate is the total cost of borrowing (or earning) and includes any other interest or fees expressed as a single annual rate.
Nominal Interest Rate (NIR)
The nominal interest rate is usually presented as the advertised rate by banks or financial institutions. This expresses the interest rate as an annual value before any interest or other fees have been added. As such, NIR percentages often look maintainable, even though they could be significantly higher after the effects of compounding or other factors.
Compound Interest
Compound interest is present in almost every loan or interest earning. In simple terms, compound interest is interest charged or earned on the new amount after interest has been added or subtracted from the principal. As such, loans with compound interest can be worth significantly more than the initial amount borrowed, and earnings from investments can also grow significantly.
Effective Annual Rate (EAR) or Annual Equivalent Rate (AER)
One of the most crucial interest rates to understand is the EAR—effective annual rate. This is the actual yearly cost or interest gain after considering the compounding interest’s effects. The EAR, also called the annual equivalent rate (AER), is the most accurate representation of the rate you receive or pay.
Calculating EAR
Calculating an offer’s EAR is relatively simple and can be done using information from multiple offers. For example, we will compare two offers, both with a 6% annual interest rate—one compounded daily and the other compounded quarterly.
To calculate EAR, the following formula can be used: (1 + i/n)n – 1, where i is the rate on offer and n is the number of compound periods (365 for one year and four if compounded per quarter).
Using the above, the two calculations can be worked out as follows:
Offer 1: (1 + i/n)n–1 = (1+.06/365)365–1 = (1+.000164)365–1 = 1.000164365–1 = 1.0618–1 = .0618
Therefore, for the first offer, the EAR is 6.18%
Offer 2: (1 + i/n)n–1 = (1+.06/4)4–1 = (1+.015)4–1 = 1.0154–1 = 1.0613–1 = .0613
Therefore, for the first offer, the EAR is 6.13%
When interest is offered as compounded per annum, the EAR will be equal to the advertised amount. Therefore, if there were a third offer based on the above rate of 6% that was compounded annually, the EAR would be 6%.
Understanding Which EAR Is Best
Once the EAR of multiple offers has been calculated, selecting which offer to go for should be easy.
For investors, the best option is the one with the highest yield. Based on the example above, option one would, therefore, be the best option as it offers 6.18% interest compared to 6.13% (option two) and 6% (option three).
If you’re lending money, however, the roles are exactly reversed. Option three (6%) will then be best as it charges the lowest amount to service your debt, followed by option two (6.13%) and option three (6.18%).
It should be noted that the EAR is subject to change. Should any of the offers in the example above have variable interest rates, the EAR of these options is also subject to change if the base rate is amended. As a simple rule, if all options have a variable rate, the order of best to worst will remain unchanged as the collective EAR for all options will change in proportion.
However, if various options offer different types of interest (variable vs. fixed), a recalculation will need to be done on EAR each time a rate changes.
