Interest rates explained
Including compound interest, AER and APR
Interest is what you pay to borrow money, or what a bank pays you on your savings. Understanding how it works helps you compare deals and see what you’ll actually earn or repay. This guide explains the key terms, including compound interest, AER and APR.
What is interest?
Interest is the money you pay to borrow, or the money you earn on savings. It’s usually shown as a percentage rate per year. The amount of interest you're charged or earn will also depend on your balance and how long you save or borrow for.
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When you save, the bank pays you interest for keeping your money with it. As an example, if you put £1,000 into a savings account paying 5% a year, you’d earn £50 interest after a full year, giving you £1,050 (assuming the rate doesn't change and you don’t add or withdraw any money).
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When you borrow, the lender charges you interest on the money you owe. For example, if you borrow £1,000 at 5% annual interest and repay everything after one year, you’d repay £1,050: the £1,000 you borrowed plus £50 interest, assuming no fees.
Most loans involve monthly repayments, so the balance you’re charged interest on usually gets smaller as you pay back the amount you borrowed.
What is compound interest?
Compound interest is simply interest on interest. With savings, it happens when interest is added to your account and then earns interest itself.
Suppose you put £1,000 into an account paying 5% a year, with interest added annually. In year two, you earn interest on both your original £1,000 and the £50 interest from year one. The longer you leave the money untouched, the greater the effect.
After… | Interest earned that year | Total balance |
|---|---|---|
One year | £50 | £1,050 |
Two years | £52.50 | £1,102.50 |
Three years | £55.13 | £1,157.63 |
Assumes the rate stays at 5%, all interest stays in the account, and there are no withdrawals, extra deposits or tax deductions.
Let's say you put £1,000 away for 20 years. If you were only earning the £50 a year, without the compounding, you'd have £2,000 in the bank afterwards. However, because of the interest on the interest, you'd actually have £2,653 - that's £653 in interest earned (assuming rate remains the stay and no funds added or withdrawn).
Compounding can also increase debts
If a lender adds unpaid interest to your balance and charges interest on it, you’re paying interest on interest. Making repayments reduces your balance and helps limit future interest charges.
What is AER?
AER stands for annual equivalent rate. It helps you compare savings accounts by showing the yearly rate, including the effect of compound interest.
For example, £1,000 saved at a constant 5% AER would earn £50 over a full year, before tax, if you leave the money and interest untouched.
What’s the difference between AER and gross interest?
The gross rate is the interest rate before tax, without allowing for the extra interest earned through compounding within the year. AER includes that effect.
For a straightforward account paying interest annually, the gross rate and AER are usually the same. If interest is paid monthly and left to earn more interest, the AER will be higher than the gross rate.
For example, an account paying about 4.89% gross with monthly interest can offer the same 5% AER as one paying 5% gross annually. That assumes the monthly interest is left to compound. If you withdraw it or have it paid elsewhere, you won’t earn that extra interest in the account.
Use AER to compare savings rates, but check any bonus period, balance limits and withdrawal conditions too.
What is APR?
APR stands for annual percentage rate - it's the official rate used for borrowing. It helps you compare borrowing costs by combining:
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The cost of the borrowing – so the amount of interest charged
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Any associated fees that are automatically included, such as an application or annual fee
An APR is therefore meant to give you the overall equivalent cost of a debt, which you can then use to compare against other credit and loan products. It must be displayed by a lender before any agreement is signed. This also means a product’s APR can be higher than its interest rate. It won't include every possible charge, such as penalties for missing repayments.
Compare APRs for the same borrowing amount and repayment period. Also check how much you’ll repay in total: spreading a loan over longer can reduce the monthly payment while increasing the overall interest cost.
Representative APR: you might be offered a higher rate
The term 'representative APR' or 'rep APR' is widely used on credit card and loan adverts, yet this means only 51% of successful applicants must be given the advertised interest rate (or better). The rest will most likely get a higher rate.
So don’t assume the headline rate is what you’ll get. Check your personal offer before agreeing to borrow.
To give you an example, if a loan is advertised as being 2.8% APR representative, this means 51% of accepted applicants have to get 2.8%, and up to 49% could be offered a different rate, which is often much higher. The same principle applies for credit cards, though this uses the interest rate for purchases, which can be different for other uses, such as balance transfers or cash withdrawals.
Of course, some people will be rejected outright for the card or loan too.
Watch out for flat-rate borrowing
A flat rate and an APR with the same percentage don’t mean the same cost. Flat-rate interest is calculated on the original amount borrowed throughout the loan, even as you repay it. With a standard repayment loan, interest is charged on the outstanding balance, which falls as you repay.
For example, borrowing £5,000 over five years costs:
At 6% APR: roughly £800 in interest.
At 6% flat: £1,500 in interest – roughly equivalent to 12% APR.
A flat rate can therefore make borrowing sound cheaper than it is. Always check the APR to compare deals, alongside the total amount you’ll repay.
See our car finance guides for more.
Interest rates FAQs
What's the difference between fixed and variable interest rates?
A fixed rate stays the same for a set period. A variable rate can change, affecting the interest you earn or pay.
If a savings account includes a temporary bonus, check when it ends and what rate applies afterwards. Set a reminder to compare accounts before the bonus expires.
What should I check besides the interest rate?
For savings, check whether the rate applies to your whole balance, whether you must make regular deposits and whether withdrawals are restricted. Make sure the account suits how you’ll save and when you’ll need your money.
For borrowing, check the monthly repayments, fees and total amount you’ll repay, as well as the APR.
Will I pay tax on savings interest?
When you earn money from most types of savings, the interest earned counts as 'income', so is liable for income tax.
However in practice, less than 5% of people in the UK pay any tax on their savings due to the Personal Savings Allowance (PSA), which means every basic-rate taxpayer can earn £1,000 interest a year without paying tax on it (higher-rate £500). Interest earned within a cash ISA is always tax-free.
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