Although it may not seem like it at first, interest rates really are interesting. High rates are great news for savers but bad news for borrowers and vice versa. Regardless of whether you’re a saver or a borrower, it’s important to understand 4 key points about interest rates.
For savers interest rates are in a race against inflation
Life is often a balancing act between conflicting goals and possibilities. In financial terms, this generally boils down to risk versus reward and/or cost versus benefit. Higher-risk investments can offer the possibility of great returns but, pretty much by definition, there is also the possibility of losing your initial investment. Cash savings can be viewed as safe in the sense that there is a relatively low risk of the saver losing their deposit, but if inflation (the cost of living) outpaces interest rates (the return on investment), savers can find their nest egg losing its value in real terms. This can be particularly challenging for older people on fixed incomes (pensioners) who do not necessarily have the long-term investment horizon of the younger generation but who do have a need for a reliable source of income to maintain themselves.
The interest rates available to consumers may be completely different to central-bank rates
About once a month, the press reports on the activities of the Monetary Policy Committee of the Bank of England, which sets the Bank of England’s interest rates. These are the rates charged (or paid) to banks which borrow from or deposit with the Bank of England. These rates may then feed through into consumer products such as savings accounts, mortgages and credit cards, some of which track this base rate. Some products, however, are fixed-rate and hence are unaffected any changes to the interest rates set by the Bank of England for the life of the fixed-rate deal. The key point to understand is that the interest rates offered to consumers are influenced by a number of factors as well as the base rate. Some of these are generic, such as what the banks think of the economy in general. Some, however, are specific to each individual, such as their credit history. Then, of course, there is the simple fact that banks need to pay their own bills and make a profit for their shareholders.
The same product can have different interest rates, applied in different ways
Credit cards in particular can charge different interest rates for purchases and cash advances (this is in addition to any fees they charge on cash withdrawals). In addition to this, the interest levied on purchases may be applied after a grace period, whereas the interest levied on cash withdrawals may be applied straight away, even if it is only actually charged when the monthly statement is created. If you would like to check this then it should be make clear in your terms and conditions, although you may find it easier just to send a message to your lender’s customer-service team to put the question to them directly.
Interest can be simple or compound
With simple interest, the interest payments are calculated purely on the basis of the initial sum deposited or lent. So, for example, if you deposit £100 then the interest you receive will always be based on that initial £100. With compound interest, however, interest is calculated on a rolling basis. Hence for example, if, after the first year you had received a total of £10 in interest payments, your next year’s interest payment would be calculated on the whole £110 rather than just the £100 you initially deposited. This is great news for savers but, of course, terrible news for borrowers and is part of the reason why those who take out high-interest credit can wind up paying more in interest than they borrowed to begin with.
