With interest rates constantly in the news, you may think you have a pretty good grasp of what they mean for your money.
But when you come to look at the options out there for savings accounts, loans, and other financial products, you may find yourself confronted with a lot of different terms and acronyms – such as APR and AER – that add another layer of complexity.
Understanding the concept of compound interest is also important for getting our heads round the different kinds of interest, so let’s start there.
What is compound interest?
Compound interest refers to earning interest not only on the initial amount deposited but also on the accumulated interest.
In simple terms, it means that as interest is added to your savings, it becomes part of the total amount and can subsequently earn additional interest.
Say you start with £100 in your new savings account, and have a 3 per cent interest rate. For the first interest payment, you receive £3, making for a total of £103. According to the law of compounding, the next interest payment will be based on your new total of £103, so you’ll receive £3.09, and so on.
The power of compound interest lies in its ability to generate exponential growth. The more frequently interest is compounded, the faster your savings can grow.
Over time, compound interest can significantly boost the value of your savings, allowing them to grow more rapidly compared to simple interest.
What is AER Interest?
AER stands for Annual Equivalent Rate. It is the interest rate applied to savings accounts or investments over a year, taking into account the effects of compounding.
It is designed to provide a standardized way of comparing interest rates across different financial products, allowing savers to easily compare the returns they can expect from various options.
AER interest is particularly important for savings accounts, as it represents the actual return on your savings when interest is added to the account more than once a year. By considering the compounding effect, AER interest provides a more accurate representation of the growth potential of your savings over time.
By comparing AER rates across different savings accounts, you can identify the accounts that offer the highest returns on your investment. The higher the AER interest, the faster your savings will grow, especially when compounded more frequently.
What is APR?
APR, or Annual Percentage Rate, is a measure used to express the cost of borrowing or the profitability of an investment.
Unlike AER interest, which is specific to savings accounts, APR is commonly used for loans, mortgages, credit cards, and other forms of borrowing.
APR represents the annualized interest rate, inclusive of any additional fees or charges associated with the loan or credit product. It lets you compare the costs of different borrowing options, taking into account both the interest rate and any associated fees.
When considering loans or credit cards, a lower APR indicates a more affordable borrowing option. By comparing APR rates, you can identify the most cost-effective borrowing solutions that minimize interest expenses.
