Interest rates explained: APR vs AER

How do interest rates work?

Interest rates are simply a percentage that you will be charged on the total amount that you borrow. So, if you borrow money from a lender, overall you will pay back more than the initial sum that you borrowed. In a way, interest rates are similar to hiring a car, it's the fee that you pay for the benefit of being able to ‘hire' someone else's money.

The single most important interest rate in the UK is the Bank of England Base Rate, which they set 8 times a year and influences what interest lenders will charge you. As a borrower, this rate is not the only one that affects you. Your interest will depend on other factors such as your personal circumstances and credit history - the better your credit score is the less interest you will pay. This is because the bank will find it less risky to lend you money.

Interest rates on savings

Interest rates are not just one way and can help you make money on your savings. Banks give you interest on money that you put into and keep in a savings account and can therefore be a useful way of building up your savings without having to actually do anything. Interest rates on savings are generally much lower and you may have to save a significant amount to get a decent return.

Compound interest

Compound interest can be a way of being charged more or making even more money on your savings. Compounding essentially means you add interest onto savings or loans where you have already added interest to. So if you are earning compound interest on your savings, every year the interest rate will be of the total money in the account, both the initial sum and the sum accrued through interest. So, if you had £1,000 with 10% interest, after year one you would have £1,100. After year two you would earn another £100 plus a further £10 on the initial £100 you earned last year.

What is APR?

An APR (Annual Percentage Rate) is how much it will cost you to borrow money on credit card and loans. When you take money from a lender they will give you an APR which is the interest rate plus any additional charges that you have on your personal loan. It's a useful number because it makes it easier to compare loans . Because there will be different interest rates for different individuals based on their credit rating, when advertising an APR lenders have to expect at least 51% of the customers who apply for it will receive this or lower.

Issues with APR

• Because lenders only have to expect 51% of people to get the advertised APR, there is a good chance that you won't get the rate advertised. If you do not have an excellent credit score you will likely fall into this category.
• The APR only includes the compulsory charges that they will take. This means that you need to carefully look at the terms and conditions of the loan as there may be hidden fees (such as Payment Protection Insurance).

What is AER?

If APR is used for debts, then its savings equivalent is AER (Annual Equivalent Rate). Essentially the AER is designed so you can easily compare between different accounts, showing you how much interest you would get if you put the money into the account. There is a key difference between the gross interest rate and the AER. The AER includes compounding, whereas the gross interest rate is purely the rate of interest on your original deposit of money.

Beware of flat interest rates

Flat interest rates are thankfully becoming less common, but if you see them you should avoid this type of borrowing at all costs. APRs work on outstanding debt, therefore it will only charge you interested on the debt that you have left with the lender.

A flat rate operates completely differently and will charge you interest on the total amount you borrowed for your entire repayment. Meaning if you borrowed 10,000 and only had 1,000 left, you would still be paying whatever the percentage was on the initial 10,000.