Interest Rates Explained
Interest rates reflect the cost of borrowing money. When you take out a loan you are charged interest on the amount borrowed. AER stands for "Annual Equivalent Rate" and it is a way to express the interest rate on a savings account or other type of deposit account in a way that makes it easy to compare the effective rate of interest you will receive.
AER takes into account the effect of compound interest and expresses the rate as if interest were paid and compounded once per year. So AER is a standardised way to compare the interest rates across different accounts, and make sure you understand the interest you earn.
Interest rates are also relevant to savings accounts but for this, they are usually referred to as the “yield” or “return” on your deposits.
Why Do Interest Rates Change?
There are several factors as to how interest rates are determined. This includes the monetary policy of the central bank (such as the Bank of England), the strength of the economy and the overall level of inflation.
- Inflation: When inflation is high, it means the purchasing power of money is decreasing and requires more money to purchase goods and services. Raised interest rates make borrowing more expensive which can slow economic growth whilst reducing inflation.
- Economy: If the economy is struggling and unemployment is high, central banks, such as the Bank of England, could lower interest rates to encourage borrowing and spending. This can help stimulate economic growth.
- Monetary Policy: Central banks can use a variety of tools to control the money supply and interest rates in the economy. For example, buying or selling government bonds on the open market can influence interest rates and the supply of money. Governments can also have an influence on interest rates through policy decisions.
What Types of Interest Rates Are There?
There are several different types of interest rates which can apply to different types of financial products. The two common types of interest rates are:
- Fixed Interest Rate: A fixed interest rate is when an interest rate remains the same over the life of a fixed term or other financial product. For example, a fixed-notice account means it’ll have the same interest rate for the entire fixed term period.
- Variable interest Rate: A variable interest rate is when an interest rate can change over time. This is typically based on an underlying index such as the prime rate, market conditions and is dictated by the bank's strategy and control.
There are different types of interest rates that can impact the overall cost of a loan. It’s important to understand the type of interest rate that applies to any given product before making a financial decision. See the best saving interest rates.
How Do Interest Rates Affect My Savings?
Interest rates can affect and benefit your savings account by increasing the amount of money you earn on your deposits. Often, when you deposit money into a savings account, the bank pays you interest on that money. This is expressed as an annual percentage of the total deposit.
When interest rates are high, it means you can earn a higher return on your savings. This can help your money grow faster. High-interest rates can also help you protect the value of your cash against inflation. This means that your savings lose less value over time.
Interest rates can vary widely between different types of savings accounts and between banks. It’s always important to do your research into savings accounts and banks to ensure you’re getting a competitive interest rate and that your money is protected by initiatives such as the FSCS (Financial Services Compensation Scheme).
