School has just started back and last week we highlighted financial education now being delivered in schools, meaning that younger generations should be better prepared and more financially responsible in later life. But for those who didn’t receive financial education, there are some common areas of finances that aren’t fully understood, like income tax, pensions and mortgages.
We recently asked you to tell us which financial decisions you wish you’d made earlier in life. Last time we talked about saving money for a mortgage deposit. For this article we’ve decided to focus on another response which came via Twitter user @pinkelle85, who said “wish I understood more about interest, 11 years later I’m still paying a £5000 loan :(“
Interest and how it works can confuse a lot of people so we thought we’d take a better look at learning the basics of interest whether you use this knowledge for savings or loans.
Financial jargon explained
In this segment we’ll cover the basics of APR’s Vs. AER’s, Compound Vs. Simple interest and 0% interest! These are all important tools for understanding the way lenders minds work and having this knowledge should help you to get the most out of your money.
APR (The Annual Percentage of Charge) applies to those borrowing money. The Financial Conduct Authority define APR as “You can use it to compare different credit and loan offers. The APR takes into account not just the interest on the loan but also other charges you have to pay, for example, any arrangement fee. All lenders have to tell you what their APR is before you sign an agreement. It will vary from lender to lender.”
The fact it includes charges does mean sometimes that APR can be a bit confusing. It’s possible that the interest rate is 14% per annum, but the APR is 17%, as the impact of the charges adds the equivalent to another 3% interest. Yet this is useful as it allows a true comparison.
If you’re a saver, then you’ll need to know about AER’s (The Annual Equivalent Rate) as it’s the official rate for savings accounts and is designed to allow easy comparisons as it’s meant to smooth out the variances between accounts (it’s the equivalent of the APR for debts).
In essence AER’s show what you’d get over a year if you put money in an account and left it there. The alternative is the gross rate, which is the flat rate of interest that’s actually paid.
If you want a bit more details on APR’s and AER’s you can find an intricate explanation here.
While we all know money doesn’t grow on trees, money does make more money in the case of compound interest savings. With a compound interest savings account, you will earn interest on the initial amount deposited and then as time goes on, you also earn interest on the interest which makes a big difference.
On the other hand as a borrower, compound interest accelerates debts because as well as paying interest on the original borrowing, you pay interest on the interest accrued. In essence, the longer you borrow for, the quicker your debts will grow.
In savings, simple interest is where the amount of interest earned is fixed over time. For example if you saved £1000 at 4% simple interest you would earn £40 per year every year.
The same is true if you are borrowing money with simple interest, the interest will remain fixed and so the debtor will only pay interest on the initial amount borrowed, regardless of the amount of time the money is borrowed for, or how much money is repaid per month.
When you are borrowing money, a 0% interest rate is often favourable as it means that the repayments will only cover the initial amount borrowed and no more. However, most 0% interest offers only last for a certain amount of time, before increasing to a higher representative APR. This means borrowers should try to ensure they’ve paid off the card, or be ready to shift the debt to a new balance transfer card to avoid paying the high fees.
First steps towards borrowing money
Now that you understand the basic financial language, if you want to enquire about borrowing some money, a good way to start is to work out the true cost of borrowing and this offers a simple guide including the questions you should consider when taking out a loan. If you are thinking about personal loans, Money Advice Service has a clear and concise guide, so you know exactly what you are signing up to from the very beginning.
If you are looking for a credit card we currently offer personalised cards based on your Noddle report with realistic estimations of the deals you could get right now.
That’s all for this week, we hope this bite size serves you well.