What Are Interest Rates And How Its Working
Interest rates can be the percentage you earn on your savings or the percentage you pay for borrowing money. Although interest rates can be calculated over shorter periods, they are often represented as an annual percentage. They vary based on the type of banking product you select, the financial provider, and other factors.
How Do Interest Rates Work?
Borrowers and savers are impacted when the Bank of England (BoE) base rate, also referred to as the bank rate, changes. Borrowing costs will likely rise if the BoE base rate rises, but savers may see an increase in interest payments. Numerous other factors, such as variations in demand and the interest rates provided by competitor banks, could also lead banks to modify their interest rates.
What is the UK Base Rate?
The Bank of England sets the UK base rate, the interest rate commercial banks pay for loans. The base rate affects banks’ interest rates to save or charge borrowers. Depending on how the economy is doing, the BoE may use the base rate to promote or discourage consumer spending. The BoE can use negative interest rates to promote growth if the economy is especially bad.
Types of Interest Rates
#1 – Simple Interest Rate:
Real and nominal interest rates can be calculated from the simple interest rate. The nominal interest rate is the specified rate used to calculate interest payments or the rate at which savings accrue over time. For example, you would receive £200 in interest if you invested £10,000 at a nominal interest rate of 2% over a year.
By subtracting the inflation rate from the nominal interest rate, the real interest rate accounts for the effect of inflation on nominal interest rates.
The actual interest rate is 0%. For example, if the nominal interest rate is 2% and inflation is also 2%.
#2 – Effective Interest Rate (AER)
The interest rate applied to savings accounts in the UK is the effective interest rate, often known as the AER or Annual Equivalent Rate.
It is calculated by adding the amount you initially deposited to the interest you earned on savings over a year. Compound interest, as the title suggests, means that any interest you earn over the next year will be calculated based on both your initial investment and the interest you earned the year before.
AER often analyses annual interest rates with various terms for compounding (daily, monthly, annually, etc.). A nominal interest rate of 5%, for example, would be equivalent to an effective rate of 5.095% when compounded quarterly, 5.116% when compounded monthly, and 5.127% when compounded daily.
How Compound Interest Works:
In essence, compound interest is interest that is paid on money that has previously accumulated interest. Although it may seem complicated, it’s important to grasp since compound interest can significantly affect the value of your investment.
Consider investing £1000 in a savings account, paying 2.5% interest. You would have £1,025 after a year. You would earn 2.5% on £1,025 the next year (your initial investment + interest accrued for a year).
Your interest in your investments will undoubtedly be subject to income tax if you are a UK taxpayer. Having a Cash ISA is most likely the only situation where this is not true. However, suppose they are basic rate taxpayers. In that case, most UK adults have access to a personal savings allowance that allows them to earn up to £1,000 in interest on their savings without paying tax. Interest income up to £500 is tax-free for higher-rate taxpayers.
Are you seeking for professionals to get advice regarding interest rates? Hire Mountview Financial Solutions in London, the UK to get any financial advice.