Credit
Understanding interest rates
A handful of concepts explain almost every product, and the advertised rate is frequently not what most customers pay.
Interest is the price of money over time, and a few concepts make almost every financial product legible.
Simple and compound
The starting distinction.
Simple interest is calculated on the original amount only.
Compound interest is calculated on the original amount plus accumulated interest, which means it grows faster over time.
Compounding frequency matters: daily compounding produces more than annual compounding at the same nominal rate.
Which works in your favour on savings and investments and against you on debt, and which explains why long-term debt costs so much more than the headline rate suggests.
The rules of thumb
Useful for quick estimation.
Dividing seventy-two by an annual growth rate gives roughly the number of years for a sum to double, which is a rough approximation that works well at moderate rates.
Which makes the effect of small differences in rate obvious: a difference of a couple of percentage points changes the doubling period substantially.
And applied to charges on investments, it illustrates why a fraction of a per cent in annual fees compounds into a large sum over decades.
APR and equivalent measures
Which exist to make comparison possible.
Annual percentage rate, or its local equivalent, includes interest plus compulsory fees expressed as an annual figure, which allows products to be compared.
The critical point: advertised rates are typically representative rather than guaranteed, and in many markets only a proportion of accepted applicants — commonly a majority threshold rather than everyone — must receive the advertised rate.
Which means the rate you are offered may be higher than the one advertised, and this is legal and disclosed in small print.
Eligibility checkers using soft searches show your likely rate before applying.
Fixed and variable
The other main distinction.
Fixed rates provide certainty of payment for a period and generally carry charges for early repayment.
Variable rates move with market or lender rates, which means payments can rise or fall.
Tracker rates follow a reference rate by a defined margin.
Standard variable rates are set by the lender at their discretion and are generally the most expensive place to end up.
Which is the practical point: knowing when any fixed period ends, and acting before it does, is worth more than choosing between fixed and variable in the first place.
Where the headline rate misleads
Common cases.
Introductory and promotional rates that revert to a much higher rate, where the reversion date is what matters.
Zero per cent finance where the cash price is higher, so the finance is paid for in the price.
Products quoting monthly rather than annual rates, which look smaller.
Products quoting a flat rate on the original balance rather than a reducing balance, which understates the true cost substantially.
And deferred interest structures where interest accrues from the start and becomes payable if the balance is not cleared in time.
Interest on savings
The other side.
Advertised savings rates may include bonus periods that expire, after which the rate falls sharply.
Gross and net figures differ where tax applies.
Annual equivalent rate figures allow comparison between accounts with different compounding frequencies.
And the real return is the rate minus inflation, which for cash held at typical rates has frequently been negative in recent years.
How interest is charged on credit cards
Worth understanding specifically.
Clearing the balance in full each month generally means no interest at all.
Carrying any balance generally means interest is charged from the transaction date on new purchases, eliminating the interest-free period entirely.
Different rates apply to purchases, cash withdrawals, balance transfers and money transfers, and payments are generally allocated to the highest-rate balance first in regulated markets.
Cash withdrawals attract interest immediately with no interest-free period, plus a fee.
And minimum payments are structured so that clearing a balance takes many years.
The comparison that matters
For any borrowing.
Total amount repayable, not the monthly payment and not the rate alone.
Which requires the term, since a lower monthly payment over a longer term costs more overall.
Plus fees, early repayment charges and any final payment.
Comparing total cost over the term is the only comparison that is not manipulable, which is why it is the one least often presented.
Putting it to use
Practical applications.
Prioritise clearing the highest-rate debt, since the rate determines the cost of carrying it.
Reduce rates through balance transfers and remortgaging, which is frequently more effective than repaying faster.
Check savings rates annually, since providers rely on inertia and the gap between best and worst is substantial.
Understand that overpaying debt produces a guaranteed return equal to the rate, which is the cleanest comparison available against any investment.
And check the reversion date on every promotional rate you hold, which is the most commonly missed item in household finance.
General information only, not financial advice. Products and disclosure rules vary by country — compare total cost over the term rather than headline rates.
