Home Finance Interested in interest rates? Here’s how they work.

# Interested in interest rates? Here’s how they work.

We all know what interest means in general terms. Perhaps you aren’t interested in an activity, or maybe a certain new person in the workplace piques your interest, hopefully, this article is interesting! In the world of finance and economics, however, interest takes on a slightly different meaning.

Interest in the context of finance is essentially the cost of using someone else’s money. There are many factors that affect interest rates including the length of the loan and the credit history of the Borrower. Paying attention to Interest can save you a lot of money and headaches. When applying for a loan you may have taken your time to compare interest rates, and generally, lower is better right? Not so fast, interest can go both ways can even work to make you more money.

## Some technicalities

Before we dive into interest rates and what to look for it will be useful to know some key terms. These acronyms and terms make the whole process seem complicated than it needs to be but knowing these terms will hopefully help you understand better. The first term I want to introduce is APR, APR stands for annual percentage rate. This is calculated when applying for a loan or opening a savings account. The rate referred to is the interest rate. The second term I would like to introduce is “principal” no, not that cranky man who ran your high school. The principal is simply the initial amount of money borrowed or lent.

## When borrowing

Most commonly you will see interest rates being advertised on loans. The internet and Television are swamped with organizations trying to entice you into taking up a loan with them, and usually, the selling point is the rate of interest. Interest rates are usually calculated annually but this can depend on the loan. The rate of interest will tell you how much interest you will be paying along with the initial principal borrowed. Using a simple sum, we can see this rate taking effect. If you have borrowed \$10000 at 10% APR, you will be required to pay back the principal plus interest, in this case, the interest owed for the year being \$1000. Pretty simple stuff, but it can get more complicated. More on that later.

## When applied a savings account

Your money can earn interest just like money borrowed. By placing your money in a term deposit or savings account, you will earn an interest rate on your money. Banks will “borrow” your money and use it to play financial markets etc. Because this money is generating income, some of this “interest” is paid back to you.

Savings accounts and term deposits usually attract a much lower APR as the risks involved with a bank borrowing your money are almost non-existent. Some financial intuitions offer fantastic interest rates on their saver accounts so don’t be afraid to shop around when looking for such a product.

## Getting tricky

Remember when I said that calculating interest can get tricky? The interest we have been talking about is referred to as “simple interest”. A trickier and more interesting (hehe get it?) form of interest is compound interest. Compound interest is an important thing to watch out for and can really beef up your savings, but you must be careful as compound interest can work both ways.

Using our previous example with \$10000 borrowed at 10% interest rate, let’s turn the tables and pretend we have put \$10000 in a savings account. Because this is a hypothetical, we can use the same APR of 10% (a VERY generous interest rate offered on a savings account!).

In just one year, our \$10000 has earned \$1000 in interest, not bad at all right? But what about the following year? The amount of money in the savings account is no longer \$10000 but \$11000 (the principal plus the interest). When interest is calculated again it will be applied to \$11000 meaning you will gain even more interest than last year.

## Compounding

This compounding of interest can have a dramatic effect. Using our example, in five years’ time, our \$10000 principal will attract \$5000. This was calculated using simple interest. Each year the principal earns \$1000, so five lots of \$1000 total \$5000. Simple! Doing the same calculations but applying compound interest, or principal earns an extra \$1100.

## What to watch out for

Compound interest seems pretty handy, right? Well, it might seem less magical to know that when borrowing money, you could be battling compound interest too so be wary when applying for a loan that uses compounding to calculate interest. Be wary of very low advertised interest rates too, as usually, they are too good to be true.

This also applies when taking out a term deposit or savings account. Some banks will offer a low introductory rate, also called a “honeymoon rate” which acts to entice customers in. After the first term is over, the rate can change to a lower rate, meaning these types of investments aren’t exactly set and forget as you will want to be cautious of the rate changes.

A common practice amongst credit card lenders is to advertise a monthly rate of interest. This is a sly trick that purposefully obstructs the whole picture.  A 2% interest rate seems fantastic, but that adds up to 24% a year! And that’s hoping the interest wasn’t compounded! Companies are legally obliged to tell you how the interest rate is calculated, if you don’t see ‘APR’ after the interest rate, some alarm bells should be ringing in your head.

Understanding interest rates can dramatically increase your financial success. Interest is everywhere and it’s up to you to find the best deals possible. Always compare the market when applying for a loan or opening a savings account for the best rates possible. The difference between manageable payments and crippling debt can be in your loans APR so be very cautious, and budget and plan accordingly.