Firstly, what is it?  Easy – we all know that it is the exorbitant charge that we have to pay on the money we borrow to buy our houses or it is that pittance that we are given on our savings. Two apparently different things, but in reality one and the same thing confused by that thing called Human Perception!  It is simply the “cost of borrowing money”.

Any transaction to lend money involves two people (parties), the one who lends and the one who borrows. The lender receives the agreed interest based upon the amount lent and the borrower pays it. Because the amount lent (the principal sum) can vary from very small amounts to extremely large amounts, a custom grew up over the centuries to make it easy to deal with all sizes of transaction in a way that is easily understood. This is called the “Rate of Interest” (or Interest Rate) and is normally stated as a percentage rate per annum.

As we have seen before the word percentage is derived from Latin, as are so many words in the English language, and means “for every hundred”. The words “per annum” are also from the Latin meaning “for each year”. So 1% per annum (one percent for each year) will be “one for every hundred for a period of one year”. 2% pa is two for every hundred for every year. 3% pa is three for every hundred for every year, and so on. The kind of money whether it is Dollars, Pounds, Euros or whatever then defines what currency is involved. So if Mr A wants to borrow from Mr B let’s say $1000 for one year at 5%pa then at the end of that year he has to pay back the $1000 plus $50 as the cost of borrowing the principal amount. If the term ( duration of the agreement) is say two years then the repayment will be $50 at the end of year one and $1000 plus $50 at the end of year two. Easy.

What happens though if Mr A wants to borrow $1,000,000 and Mr B doesn’t have that much? Then Mr A either has to find someone with enough money or has to find a group of different people who will lend him enough small amounts to make up his total. That makes life difficult, so as we have seen before in these blogs, the custom of a middleman grew up, whereby the middleman (a bank) paid the interest to people who had spare money  and then lent this money in larger chunks to businesses so that they were able to trade and collected interest from them. The first group are the “savers” and the latter group are the “borrowers” However the middlemen incurred expenses of their own in giving this service which they could only recover by creating a “spread” into the rates offered. For example, the rate offered to savers would be say 4%pa and the rate charged to borrowers would be 5%pa and the 1%pa difference was used to pay all of their own costs and give them a payment for the service.

But then the governments step in, in the nature of the taxman, and say ” I want a bit if that too” so the rates have to widen to say 4%pa and 5.5%pa so that the tax can be paid.

A word of warning though to all of you borrowers. Most lenders are very reputable organisations but there are always some unscrupulous people out there whose sole aim is to take you for a very expensive ride and these people avoid using the standard custom wherever they can. For example, if Mr A wants to borrow £120 he may be offered it for 24 monthly repayments of £7. It sounds reasonable because it is only £7 per month, but 24 x 7 = 168 so the interest charge is £48 over two years. A simple calculation would be one half of 48 for each year = 24 based on a loan of 120 therefore the annual rate of interest would be 24 divided by 120 multiplied by 100 = 20%pa. That is a very expensive loan!  BUT, the true position is much worse because the original loan was being paid off at the rate of $5 each month within the £7, so the true rate has to be calculated on the average value of the loan over the two year term. This was 120 for the first month, 115 for the second month, 110 for the third month, 105 for the fourth month, and so on until the final payment is made to clear it on the last day of the two years. The real rate of interest charged is therefore £24 per annum based on the AVERAGE amount lent and this is £60. So the real rate charged is 24 divided by 60 multiplied by 100 = 40%pa!!

Because many people in the UK were being caught like this, particularly poorer people who could not afford it anyway, a law was introduced which says that ALL loan offers have to quote what is called an APR. This means Annual Percentage Rate and is the true annual rate of interest being charged on the loan. ( In the illustration above it would be 40%pa) So look out for that APR it is very important to your financial health.

Then for savers there are two types of interest – Simple and Compound. Simple interest says that at the end of each calculation period ,usually one year, the amount of interest will be paid out in cash leaving the principal sum to start earning interest again. So it becomes a regular source of income of a regular amount provided the rate and the principal do not change.

Compound interest does not pay out the interest but leaves it to be added to the principal amount so that the principal grows bigger and bigger each year and consequently earns an increasing amount of interest each year. In other words it earns interest upon interest and grows more rapidly as time progresses.

Compound is obviously the better if the money is not needed but many pensioners rely upon simple interest to boost their pension income when they retire from regular work.

Finally, the rate offered is affected by a number of things. Two of the most important are Risk and Supply. The greater the risk that the principal will not be repaid promptly by a borrower then the higher will be the interest rate charged, until very high risk means no chance of a loan at all.

The other thing – supply – we have seen before when discussing inflation. If there are too few lenders and money is consequently in short supply then the rates will increase to persuade people to save more and this increase will deter borrowers and bring supply and demand back into balance.

So you see, interest does affect you and your finances, so think about it and try to use your knowledge to make your life easier.