When it comes to interest, there are a lot of terms thrown around that all mean different things. So, let’s have a look at these now…
What is interest?
Interest is worked out as a percentage. Depending on what it’s applied to, it can be the cost of borrowing or the reward for saving or investing.
If you borrow money off a lender, you will usually have to pay back what you initially borrowed with the addition of interest. In this instance, interest acts as the cost of borrowing.
If you save money, your bank may give you interest on the money you save with them, making it a reward for keeping money with that provider’s account.
Nominal Interest
Nominal interest is the interest rate before accounting for inflation. Something to bear in mind when borrowing money is that many lenders will advertise their interest rate in nominal terms, which means it doesn’t account for inflation, any fees, or any compounding of interest.
Real Interest
Real interest is the true cost of funds to the borrower, or true yield to the investor or saver. It is the nominal interest rate minus the rate of inflation… so real interest rates account for inflation and nominal interest rates don’t.
Where nominal rates look at the actual cost you pay for interest (or actual reward earned), real rates measure the cost or reward in terms of purchasing power (i.e, not just the numerical value of interest, but what this value represents in terms of what it can buy).
Compound Interest
Compound interest is when interest begins to earn interest itself. So, let’s imagine you have a savings account which gives you 5% interest on your savings added at the end of each year. If you have £1,000 in this account by the end of the year, you will have earned £50 in interest, making your new balance £1,050.
If your savings account allows for compound interest, and you still have £1,050 in your account at the end of the next year, your new balance would be £1,102.50. This is because you will have earned interest on the sum of your savings and on the interest previously added.
APR
APR stands for annual percentage rate, and is the cost you pay each year to borrow. It reflects the interest rate for the full year (rather than a rate that changes monthly) as well as any fees you have to pay to get the loan.
Fixed Interest
Fixed interest is where the interest rate stays the same for a fixed amount of time.
Let’s imagine you take out a fixed rate mortgage where the interest rate is fixed for 5 years. With this, you would only have to pay the agreed upon amount of interest for those 5 years, regardless of what happens to interest rates on the market.
After this period has elapsed, you will then move onto a standard variable rate mortgage.
Standard Variable Rate
Standard variable interest rates fluctuate depending on their underlying benchmark interest rate, e.g, the Bank of England.
Therefore, you can expect these types of interest rates to go up or down over time.