Understanding Interest on Savings and Borrowing
Interest rates are quoted in ways designed to be comparable, and the comparison only works if you know which figure you are looking at.
The two headline figures
For borrowing, the annual percentage rate includes interest plus most compulsory fees, expressed as an annual figure. It is the number to compare between loans.
For saving, the annual equivalent rate shows what you would earn over a year with compounding included, which makes accounts with different payment frequencies comparable.
Comparing a borrowing rate against a savings rate directly is not meaningful, since they are constructed differently.
Compounding
Compounding means earning or paying interest on interest already accrued. The more frequently it is applied, the larger the effect.
For savings the difference between annual and monthly compounding is real but modest at typical rates, which is why the annual equivalent figure is the useful comparison.
For borrowing it matters more, particularly on credit cards where interest is usually calculated daily. A balance carried for a month accrues more than a simple monthly calculation suggests.
What the rate applies to
On a repayment loan, interest is charged on the outstanding balance, which reduces each month. Early payments are therefore mostly interest and later payments mostly capital.
On a credit card, interest usually applies from the transaction date if the previous balance was not cleared in full, which removes the interest-free period entirely.
On savings, check whether the rate applies to the whole balance or in tiers, since some accounts pay a headline rate only up to a limit and much less above it.
Fixed and variable
A fixed rate does not change for the stated period. A variable rate can change, usually with notice, and frequently follows a reference rate.
For borrowing, fixed provides certainty of payment. For saving, fixed protects against falls and prevents benefiting from rises.
Introductory and bonus rates expire. Diarise the expiry date when opening any account, since the rate afterwards is frequently far lower.
Tax
Interest earned is generally taxable as income, which reduces the real return by your marginal rate.
Tax-advantaged savings wrappers, where available, should generally be used before taxable accounts, since removing the tax frequently exceeds any difference in headline rate.
The practical points
Compare borrowing on APR and total amount repayable. Compare saving on the annual equivalent rate.
Check what the rate applies to and when it changes.
And remember that a rate below inflation means the money is losing purchasing power even while the balance rises, which is the reason cash is a poor home for money you will not need for many years.
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