Interest rate

The interest rate is the price of money. When you borrow, it is the extra amount you pay for being able to use the money right away. When you lend money instead, to a bank on a savings account, say, it is your reward for waiting.

It is almost always quoted as a percentage per year. The abbreviation p.a. stands for per annum, that is annually.

Why 5% is not always the same thing

Here comes the catch that confuses most people. Two products can carry the same figure on the leaflet and still leave you in a different place. Three things decide:

How often the interest is credited. Credited once a year, you get exactly 5%. Credited every month, the interest starts earning further interest and the actual return is higher. That is precisely what the effective interest rate is for.

What it is calculated on. With simple interest the interest is always calculated on the original amount. With compound interest it is calculated on a growing balance and over the long run that is an enormous difference.

What the price includes. On loans the rate alone covers neither fees nor compulsory insurance. That is why loans are compared by the APRC, not by the interest rate.

The formula

The interest for a single period is simply:

$$\text{interest} = \text{principal} \times \text{rate}$$

Where principal is the amount it is calculated on and rate is the interest rate as a decimal, that is 0.05 for 5%.

If interest is charged more often than once a year, the annual rate is first divided among the periods. With monthly crediting the monthly rate is $r/12$.

What it means in practice

You meet the interest rate in every financial product. On a mortgage it determines how much you overpay: on a €200,000 loan a difference of one percentage point means tens of thousands of euro. On a savings account it determines whether your money at least keeps up with inflation. On a credit card it tends to be the highest of all, and it works against you.

So when comparing offers, never look only at the figure on the leaflet. Ask how often interest is charged and what is included in the price.

Try it yourself

In the mortgage calculator you can see how the rate changes both the monthly instalment and the total overpayment. In the compound interest calculator you can compare different crediting frequencies.