Interest rates have a big effect on people who either take out a loan or store money in a savings account. This means that it’s vitally important to understand what your interest rate is, and you should know how to calculate interest rates.
When you’re storing money in a savings account, banks will pay you a small amount to keep your savings there. This is because they can lend out the money to other people and make use of it while they are storing it for you.
On the other hand, when you borrow money, you will be accruing interest on the loan, which will have to be repaid. This is how the bank or lender makes money on funds that they have lent out to others.
In this guide, we’ll look at fixed and variable interest rates, as well as APR and how to calculate simple interest rates, as well as different types of interest rates that you might come across.
What are fixed interest rates?
Fixed interest rates are often found on larger loans, such as mortgages or personal loans exceeding £10,000. With a fixed rate, the interest stays the same for a specified period, making it a predictable and stable option. This means that regardless of fluctuations in the broader economy, your repayment amounts will not change during this time.
Advantages of fixed interest rates
Fixed interest rates provide borrowers with several benefits, including:
- Stability and predictability: Since the interest rate remains the same, your monthly payments will be consistent, making it easier to plan and budget for the long term.
- Protection against rising rates: If the overall market interest rates increase, your fixed rate won’t be affected, which can save you money over time.
- Easier comparison of financial products: Fixed rates are straightforward to compare, making it easier to choose the best loan option. For a more detailed understanding of different loan types, check out our longer term loans guide.
Drawbacks of fixed interest rates
However, fixed interest rates also come with potential downsides:
- Higher initial rates: Fixed rates can sometimes start higher than variable rates because they offer stability.
- Limited benefit if rates fall: If the market rates drop, you won’t benefit from lower payments until the fixed period ends.
How to calculate fixed interest
To calculate the interest on a fixed-rate loan, use this formula:
Total Interest = Principal Amount × Interest Rate × Loan Term
For example, if you borrow £20,000 at a fixed rate of 5% for 5 years, the calculation would be:
£20,000 × 5% × 5 = £5,000
This means you will pay £5,000 in total interest over the course of the loan, with a fixed monthly repayment amount.
Fixed interest calculator
Using an interest calculator can simplify these calculations, helping you estimate your payments quickly. With most calculators, you just need to input the principal amount, interest rate, and loan term to get an instant overview of your expected payments. This tool is particularly useful for comparing various loan options.
Fixed interest examples
You may encounter fixed interest rates in various financial products, including:
- Mortgages: Many homeowners opt for a fixed interest rate to keep their mortgage payments stable, especially in the initial years of the loan.
- Personal loans: A fixed interest rate on a personal loan ensures that you know exactly how much you’ll be repaying, which is crucial for higher-value loans over £20,000.
- Auto loans: Fixed rates are common on car loans, giving you peace of mind about your monthly vehicle payment.
Fixed interest for someone borrowing
£25,000 × 6% × 4 = £6,000
So, you would pay £6,000 in total interest over the 4 years. Because this is a fixed rate, your monthly payments will not change, making it easier to manage and budget your repayments.
You can also consider secured loans if you’re borrowing against an asset, which may offer different terms.
Fixed interest for a savings account
With a fixed interest savings account, you deposit a lump sum of money, and the interest is calculated based on a fixed rate for a set period. For example, if you deposit £10,000 at a 3% fixed rate for 3 years, your interest calculation would be:
£10,000 × 3% × 3 = £900
You would earn £900 in total interest over the 3 years, without any changes to the rate.
Other interest rate types
In addition to fixed interest rates, it’s important to understand the other interest rate types you may encounter. Each type works differently and can impact the overall cost of a loan or the returns on a savings account.
Compound interest
Compound interest is calculated based on the initial principal and the accumulated interest from previous periods. This means that you earn (or owe) interest not only on the original amount but also on any interest that has been added over time.
For example, if you deposit £10,000 at an annual 5% compound interest rate, your first year’s interest would be:
£10,000 × 5% = £500
In the second year, you would earn interest on £10,500 (the initial amount plus the first year’s interest), resulting in:
£10,500 × 5% = £525
As you can see, compound interest can quickly grow your savings or increase the amount you owe on a loan if not managed properly.
Variable interest
Variable interest rates are influenced by the broader market and typically fluctuate based on the Bank of England’s base rate. This means that your repayments could increase or decrease, depending on the current economic climate. For more insights on how these loans compare to others, check out our article on short vs long-term loans.
Advantages of variable interest rates
- Potential for lower costs: If interest rates drop, your repayments may decrease as well.
- Flexibility: Variable rates can offer flexibility, especially if you plan to pay off the loan quickly or if you anticipate that rates will fall.
Drawbacks of variable interest rates
- Unpredictable payments: Your monthly payments could increase unexpectedly, making it harder to budget.
- Risk of higher costs: If the base rate rises, so will your loan repayments.
How to calculate variable interest
Calculating interest for a variable rate can be complex because it changes over time. Typically, you would recalculate the interest whenever the rate changes. For example:
If you have a £20,000 loan with a variable interest rate that starts at 4% and rises to 5% after the first year, the interest for each year would be calculated separately:
- Year 1: £20,000 × 4% = £800
- Year 2: £20,000 × 5% = £1,000
This shows how variable rates can lead to fluctuating costs over the term of the loan.
Annual Percentage Rate (APR)
Annual Percentage Rate (APR) provides a more comprehensive view of the cost of borrowing. APR includes the interest rate as well as any additional fees or charges, making it a valuable metric when comparing loans.
For example, if a loan of £20,000 has a 5% interest rate but an APR of 6%, the additional 1% could represent fees such as arrangement charges or annual service fees. Always consider the APR alongside the interest rate to get a clearer picture of the overall cost.
Why calculate interest?
Working out the amount of interest you have to pay can help you weigh up which financial product is best for you. When you are looking for a loan or mortgage, you might be tempted to get the product with the lowest interest rate, but this might work out to be more expensive when you factor in fees or interest type. Similarly, with savings accounts, a high standard interest rate might be lower long-term compared to a compound interest rate. Knowing how to figure out interest rates can help you make the right decision for your financial future.
Summary
Understanding the differences between fixed and variable interest rates, as well as APR, is crucial when borrowing money. Always consider both the interest rate and the APR to get a true sense of the cost of a loan. For higher-value loans, these factors can greatly impact your financial plans.
With a solid grasp of how interest rates work, you can make more informed decisions and choose the best financial products for your situation.