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Interest

How shall I start with such a complex topic with more twists and turns than a game of murder mystery? In my opinion, the whole subject of Interest is a bit like a boozy night out; at the end of it, you are generally hungover. Almost the same thing applies to Interest. The more you get into it, the greater the chance for an actual headache. There are many things to get your head around, but I would not be the Jolly Beancounter without trying to make it look simple! And simple, it is by just focusing on a few points! 

The former UK Prime minister (don't who exactly, there were just too many recently) once said that there is no such thing as a magic money tree. I think I have to partially disagree with this statement. While I don't dispute that money doesn't grow on trees I think there are ways to get money without actually having it. 

I am talking about credit, which is money we don't have ourselves but others are willing to give us for a small and sometimes not-so-small cost or, in financial gibberish called "interest". 

Interest is not always a cost to you! If you lend money to someone you can equally charge interest and earn it for yourself. But throughout the next lines, I am primarily referring to its tricky side, when it becomes a cost to you.

And tricky it is indeed because of how it is sometimes presented or advertised to us. I am purposefully saying advertised because "advertising" is the art of convincing or seducing us to buy something! 

So naturally, you want to make it sound attractive, whether it is a new Laptop or a credit plan to buy a new laptop. 

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Lets get behind the most common lingo

Variable and fixed interest rates

You will often hear people talk about fixed or variable/floating interest rates. The main difference is that over the loan or credit period one fluctuates the other one not.

You see there are two essential building blocks of the interest you get charged, this is better understood with an illustration.

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I have constructed two interest towers in the illustration above, Tower 1. "Variable Interest," and Tower 2. "Fixed Interest." Each of the two towers is made up of a foundational block set/built by each country's central bank. They set a base rate to keep the monetary policy going in the right direction (i.e., fighting inflation, providing a sound lending environment, and stable money supply). Your local bank has to bake that into the interest rate they offer you! The reason is that your local bank uses the central bank base rate to finance itself, so it is only prudent to onward charge you these costs plus a little extra to cover its expenses such as staffing, etc...

An example:

In the good old times when things were much more straightforward forward, your local bank was a good companion who provided credit and other means such as current and savings accounts to help you do business. Banks were useful intermediaries because central banks were not mandated to provide all these services to end customers. Their only task was to keep the wheels of the broader economy greased enough! Hence commercial banks came into existence that was far better equipped to deal with the needs of end customers! Imagine you founded a bank. You would get your initial capital from the central bank at the base rate of, let's say, 2%. If you borrow a 1.000.000GBP, this will amount to an expense of 20.000GBP annually. But this is not your only expense. Imagine you have an employee working for you, making all the contracts, etc... One day, a client approaches you with an idea to establish a brewer with the catchy name "The Jolly Brew Ltd." He needs 1.000.000GBP. No problem, you have that amount handy the only question remaining is how much to charge in interest. The 2% set by the central needs to be onward charged; this is a no-brainer as we have to cover these costs no matter what. But we need to take of other costs we have such as the staff wages. So we need to figure out an additional bank margin! We have staffing costs worth 30.000GBP, which is 3% of 1.000.000GBP. With this in mind, we could charge the customer a total of 5%, which covers both the base rate and our internal requirements. And if we want to profit, we charge an extra 0.5% for good measure. 

This was a very simplified example, but it is not too far away from reality and explains the building blocks of bank interest rates pretty well! 

Variable Interest:

As the name says, variable interest fluctuates over time. The portion allowed to fluctuate is building block 1. (the central bank base rate). For example, imagine you have bought a car on a variable finance rate, each time the BoE changes its base rate, the variable rate of your finance deal will change. It makes sense as the bank passes the cost of the rate change on to you. 

Fixed Interest:

With a fixed interest rate, there won't be any changes to the rate you are being charged over the entire contract period. Look back up to my building block illustration. Do you notice that the fixed interest tower is slightly higher than the variable interest tower? This is for a good reason, as fixed-interest deals are usually more expensive. Quite logical because the longer the term of the finance deal you have (either 5 or 10 years), the more unpredictable it will be for a bank to determine where the central bank base rate will be! Hence they will charge you slightly more to cover this uncertainty.

When you decide which rate to go for, either fixed or variable, you have to determine which is more financially sound. And let's face it when the central bank rate is around 0%, why would you not be inclined to fix it over a reasonable period? Should you nonetheless decide to go for a variable rate, calculate a few scenarios where it could go, and put some money aside? However, I like to work with a fixed rate because it removes all the uncertainty when potential future costs arise from base rate changes. 

The difference between AER and APR

Last but not least, I want to discuss two common ways of calculating interest.

AER - Annual Equivalent rate: Quite simply put: this is the annual interest you get for your bank savings if you don't touch them for an entire year! Let's assume you saved up 10.000GBP and left it in your savings account for a year. The bank rewards you for it by giving you a 2% interest on your savings. The calculation is easy: you calculate 2% on 10.000GBP, which is 200GBP, this will then be added to your 10.000GBP, and the following year through the wonders of compounding, you will get a 2% on your 10.200GBP, money then literally starts growing! 

By now, you should know that fiance people like their lingo so quickly. Let me introduce you to EAR - Equivalent Annual Rate. This is nothing else than AER, but whilst AER is calculated on savings, EAR is being used for borrowings! That simple! 

Now let's discuss APR!

APR - Annual Percentage Rate is what I call the "all-inclusive" rate that represents a broader measure of your borrowings as it includes not only interest but also any applicable fee. Although a slight warning at this point! It does not include any fines or late payment fees. 

In theory, it makes it easier for consumers to compare offers, but a percentage figure is just a percentage figure! It needs to be put into context! And for this, we need another jolly example:

The example above shows a fancy laptop deal with a representative APR of 24.8%. By the way, I am learning myself every day. Only in 2022 I finally figured out what a "representative APR" stands for. You see, whenever you turn on the tele, they talk about representative APR, like in the above ad. Whoever advertises a representative APR deal (e.g., a loan for a new laptop) has to offer that rate to at least 51% of customers who are successful in their loan application. The other 49% will be offered a different APR which usually tends to be higher. 

One thing that clearly sticks out is the total cost of borrowing of 382 over 3 years! This is the price you pay for having the laptop now instead of saving up for it! I think you always have to figure out the real money impact because otherwise, these percentage figures mean nothing! It will make you think twice whether you need this laptop, TV, or car right now.

You can quickly build this table in excel yourself; see the instructions below:

I hope you had fun learning about interest rates! And don't forget to consider it before you next hit the buy button!

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