How to understand interest rates

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You probably see banks and finance provders advertising different interest rates, but do you know what they actually mean? Once you're clued up on how to understand interest rates they can become a really easy way for you to compare offers, and get the best deal.

Let’s start with a practical example:

You and your family are going on holiday and want to do some cycling however do not have the right car to transport your bikes from home. Renting your bikes in the local area seems the best option. The local bike rental offers you one week’s rental for £100 per bike. This is far more convenient than trying to transport your own bikes and you go for the offer.

This example can help us understand interest on loans really easily. In the same way the bike vendor is charging you rent on his bikes, loan vendors are charging you rent on the money they loan you. The need to rent bikes came out of convenience and necessity as the family might have access to their own bikes in the future however right now they need bikes but do not have them. The same can be said for money borrowing money. You need the money right now and don’t have it but know that you will have it in the future.

The family will return their bikes a long with the rent paid, the same as you will return the amount loaned with the interest paid on the money, or rent if you will. This is a really simplified way to understand interest.

Here’s how simple interest is worked out:

Ian borrows £1000 from the bank. The interest he has to pay on his loan is set at 6.9% meaning he has to pay the full amount including 6.9% rent on the money.

The interest on the loan is therefore £69 which now gives the new balance to be paid back which is £1069.

The way in which interest rates are set by the banks is a lot more complex to understand and we are only attempting to understand simple interest rates today. This basic understanding of interest rates can really help to your basic understanding of money and how you see borrowing and lending. It may seem fairly obvious but seeing money in more physical terms can help us to prioritise our borrowing. Often banking and loans can feel like a bunch of numbers on a screen.

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