Interest can be applied to both money borrowed and money saved. When money is borrowed, interest is applied to that money as a charge to the borrower, while when money is saved interest is added as an incentive to the saver.
For borrowers, interest rates give an indication of the cost of borrowing (though this does not take account of any flat rate fees); in general, the higher the interest rate the more expensive it will be to borrow as more money has to be paid back. The interest rate quoted can be affected by the credit rating of the person applying: usually the better their credit rating the lower the interest rate, all other things being equal.
For savers, however, interest rates show the rate of return on their investment. The higher the rate, the more money they can expect to earn on their premium bonds, ISAs or savings-based bank accounts.
The most basic type of interest is known as simple interest. In this type, any interest calculated is based solely on the amount borrowed, with no consideration given to any additional debt incurred from interest levied on previously accumulated interest.
Compound interest is more complex than simple interest. When compound interest is charged, interest is calculated not only on the amount initially borrowed, but also on any debt that accumulates due to interest charges. This means that debt can accumulate very quickly, especially on high interest consumer credit items such as payday loans. Any borrower taking out a product subject to compound interest should think hard before committing, as debt incurred can quickly become unaffordable. At the very least, they should try to obtain a quote as to the total amount of interest charged over the life of the debt: this will allow them to make an informed decision.
Annual Percentage Rate
When selecting a loan, mortgage, credit card or overdraft, it is important that any potential borrower tries to accurately assess any possible interest charges. The standard method of doing this is by assessing the Annual Percentage Rate, or APR.
There are two versions of this measure: the first, nominal APR, represents the simple interest rate for one year of the debt. Though this can be useful, it can be misleading as it does not take into account compound interest or any fees associated with the money being borrowed.
Effective APR, or EAR, is generally held to be a more accurate way of assessing the cost of borrowing. Before using it, however, the potential borrower should check which type of EAR is being used as different lenders can use different definitions. Some lenders use a definition of EAR that includes compound interest but excludes fees; others use a definition that includes both compound interest and fees. If the former definition is being used then the borrower should ask their lender to provide additional information so they can assess how much their debt will be when compound interest and all related charges are included. Failing to do so could result in the borrower taking on debt they cannot afford, leading to debt problems later on.
If such problems do occur, it is recommended that the borrower takes advantage of the free debt advice available from a variety of charities and government bodies.