What are interest rates and how do they work?

What are the types of interest rates?

There are different types of interest rates, identified by who issues them. These are:

• Central bank interest rates –national interest rates adopted by a country and determined by that country’s central banking authority. In the case of the UK, that’s the Bank of England. In the United States, this is the Federal Open Market Committee (FOMC)
• Bank account interest rates –interest rates set by local or regional banks, which are affected by the central bank’s rates
• Mortgage interest rates –rates on loans, such as home loans for those buying a new house, given out by lenders like banks

How do interest rates work?

Interest rates come part and parcel with the loan you’ve taken out, or as part of the savings you’ve amassed. In the case of a loan, your total loan repayments plus the calculated interest amount would be divided into a monthly sum for you to pay (as a minimum amount – you can always pay more).

In the case of savings or investments, the interest rate would be the amount that your savings appreciate each year. Either way, the interest is indivisible from the total amount – and the interest rate is how much that amount grows by.

Example of interest charged on borrowing

The same is true of a loan. Let’s say you approach your bank for a home loan of £100,000. If the bank grants you that loan, they will charge a certain amount of interest on top of the loan. This may be worked out as a fixed amount, a variable amount that depends on economic conditions or a percentage payable annually, among the various types of loans you may acquire.

Let’s say you get a fixed loan for £100,000 with fixed interest rate of 4%, with monthly payments calculated on the length of your loan. If you were to take out the loan for a 50 month period, you would not only have to pay £2000 each month (£100,000 divided by 50 months) but an additional 4% of that monthly amount (£80) payable due to interest. So, you would have £104,000 (£2080 x 50 months) to repay for a £100,000 loan.

What is APR and how does it differ from interest rates?

'APR' is the Annual Percentage Rate charged by lenders, which is different to your interest rate.

A lender like a bank will often also charge small additional amounts for services rendered over and above the interest. Examples of this would be a fee for opening the mortgage at the start or closing it when the loan term is up, or broker fees.

For this reason, lenders advertise an ‘APR’ rate, which gives you the total cost of both the interest and any of these additional payments in one amount. It is often a more accurate way of depicting the true cost of your loan, without any hidden fees lurking.

What is compound interest and how does it work?

Compound interest is a wealth generation phenomenon, where your interest on savings begin to earn interest. This ‘interest on top of interest’ means that your money continues to grow itself.

Let’s look at our previous example to illustrate this better. If you have £1000 in a savings facility where the interest means it grows by 5% per annum, that would be £50 for the first year. However, this does not mean your savings grow by a static £50 each year – instead, in your second year, your amount will now grow by 5% of £1050, which is £52.50. In the third year, you would earn 5% interest on £1102.50. By the end of the tenth year, your £1000 has grown more than one and a half times to over £1600.

As you can imagine, this has a snowball effect and gets exponentially bigger over longer periods of time.

Compound interest is a wealth generation phenomenon, where your interest on savings begin to earn interest. This ‘interest on top of interest’ means that your money continues to grow itself.

Let’s look at our previous example to illustrate this better. If you have £1000 in a savings facility where the interest means it grows by 5% per annum, that would be £50 for the first year. However, this does not mean your savings grow by a static £50 each year – instead, in your second year, your amount will now grow by 5% of £1050, which is £52.50. In the third year, you would earn 5% interest on £1102.50. By the end of the tenth year, your £1000 has grown more than one and a half times to over £1600.

As you can imagine, this has a snowball effect and gets exponentially bigger over longer periods of time.

Compound interest works the other way, too. If you were to take out a loan of £2000 with an interest rate that meant the interest compounded 20% annually, after just three years, the total payable amount would be £3456 – almost double your loan amount – as 20% of the total keeps growing in size with each year.

How are interest rates decided?

Interest rates for traders and investors

On a surface level, a higher interest rate will mean more profit for investors, as the rate at which their investments grow is accelerated.

For traders, however, this goes deeper, as the very conditions around changing interest rates are waves and swells in the market that can be traded for profit – or at a loss. A sudden change in interest rate stance can lead to much volatility in the marketplace, which can be an opportunity to trade.

For this reason, most traders and investors will watch interest rates and the discussions around them with great interest and attention.

You can trade on interest rates directly by speculating at key times on whether interest rates will go up or down. This can be done with derivative products like spread betting and CFDs, and can be done on our platform.

However, speculating on interest rates is a complex and risky form of trading that comes with inherent potential loss. Also, both spread bets and CFDs are leveraged financial products. You would put down an initial deposit to open a larger position, with both profits and losses being calculated on the total position size. This means that leveraged products carry inherent risk of your losses or profits substantially outweighing your initial deposit.

Learn how to trade interest rate derivatives

Interest rates often have a knock-on effect on stocks, too. A lower interest rate could mean higher earnings from stocks, as businesses spend more in the more dovish environment. As people spend more on other things, so investors and traders spend more on stocks. This, in turn, can drive the price of those stocks up – which could drive the price of whole indices up, creating a virtuous circle where stock prices keep increasing.

The opposite can be said of a more hawkish environment. With many tightening their belts, including businesses and those buying or trading the stocks of those businesses, less money is spent. Enough people not buying or trading stocks can in turn drive the price of stocks down, both for individual companies and collectively.

Bonds, meanwhile, have a very different relationship to interest rates. Generally, when interest rates rise, bond prices fall and vice versa.

Because the amount of interest a bond can yield is partially affected by the interest rate, a lower interest rate will decrease the yield of a bond coming out now. However, there are always multiple bonds in circulation and a bond issued at the time of higher interest rate (thereby giving higher yield) will suddenly become more popular, further driving up that bond’s price due to its popularity.

In this way, lower interest rates drive down bond yields but can drive up bond prices – and the opposite is true for a higher interest rate.