Interest rates are a percentage of a principal sum of money that is lent, borrowed or deposited.
A number of financial products including personal loans, home loans, credit cards and savings accounts use interest rates.
Some types of interest cost you money, while you can earn money from others. For instance, your savings account interest rate will earn you money, whereas interest on your credit card will cost you.
If you borrow money, you will usually pay interest on the money that you borrow. The higher the interest rate, the more you'll need to repay on the loan.
For money that is deposited (e.g. into a savings account or term deposit) or lent by you, you will earn interest on the principal sum. The higher the rate, the more money you'll receive.
There are two types of interest: simple and compound.
Simple interest
This is calculated on the principal sum, or original amount, of a loan or savings/deposit. This form of interest is cheaper if you are paying it down on a loan.
Compound interest
This is calculated on the principal and on the accumulated interest (i.e. "interest on interest"). This form of interest is preferable if you have investments or savings that you are being paid interest for.
The total interest either earned or paid depends on the principal sum, the interest rate, whether the interest is simple or compound, the compounding frequency and the length of time over which it is lent, borrowed or deposited.
Interest rates can be structured and charged depending on the lender and the product. It's important to know how interest rates work, so you know how to compare products and find the right one for you.
This will depend on the type of financial product you're comparing. You can use the rates below as a guide to what could be considered a "high" rate:
These numbers are taken from our database of hundreds of financial products. You will often see "p.a." after the percentage symbol in an interest rate. It stands for "per annum" and means the rate is an annual rate. With financial products, annual interest is calculated regularly (usually daily) as you make regular repayments to a loan or put more money into your savings account.What does p.a. mean?
The annual interest rate is important because it gives you a good idea of how much money you are going to earn from your investments (in the case of savings accounts and term deposits) or how much you are going to pay on your finance (in the case of loans and credit cards).
Interest is calculated differently, depending on whether the interest is simple or compound. The formulas for each are as follows:
Paying interest on finance, such as credit cards, home, personal, business and car loans, is done for a variety of reasons. Predominantly, it's because lenders are businesses and receiving interest payments for lending money is how they make a profit. Interest rates are also paid for the convenience of acquiring finance that you did not earn or save and for the inconvenience on the part of the borrower of lending it.
Interest rates are also charged in case borrowers default on loans. For example, default rates on personal loans stand at around 3.5%, but if interest is paid on all loans lent, that risk is mitigated and accounted for and lenders will still make money, even with this expected loss.
Whether you need a high or a low interest rate will depend on the type of financial product that you're talking about.
If you're looking for a term deposit or savings account, you'll typically want to get the highest interest rate possible, so that your investments make you the most money possible.
If you're looking for a loan, you'll generally want to aim for lower rates. Paying a lower interest rate on a loan will usually mean that you pay less money over the life of the loan.
However, this is not always the case as some loans may have low rates but high fees attached. Always look at the comparison rate when considering the overall cost of a loan.
You may also want to opt for a loan with greater flexibility or additional features that cost slightly more, but are specifically beneficial to you, such as a redraw facility or repayment flexibility.
It isn't always necessarily better to have the lowest interest rate on the market.
The comparison rate is a representative rate that includes both the interest rate and fees. It's useful to look at the comparison rate when considering products as it shows you the true cost of the loan, not just the rate or the fees separately.
There are two main types of interest rates: fixed and variable.
Interest works very differently depending on the type of product you have:
Credit cards come with variable, annual interest rates. The rates vary a lot depending on what features the card offers, but you can generally find a basic, no-frills credit card for between 8-13% p.a. while a rewards or feature-packed card can set you back between 17-22% p.a.
You will find two types of interest rates on a credit card: purchase rate and cash advance rate. The purchase rate is what you're charged to make purchases on the card and the cash advance rate is what you're charged to withdraw cash using the credit card. Credit cards can also offer special interest rates such as introductory 0% rates or balance transfer rates.
Another feature of credit cards is interest-free days. This refers to the period of time between making a purchase and when you will be charged interest on that purchase. If you pay off your credit card balance during this period, you will not be charged interest. Most credit cards offer 55 interest-free days.
Personal loan interest rates can be fixed or variable and are annual rates. These rates used to very much reflect the market, specifically the cash rate, but lenders have recently been moving towards personalising interest rates based on how risky it is to offer you the loan.
This is why there are now two types of interest rates you will see advertised for personal loans: set rates and risk-based rates. Set rates will be given to everyone who is approved for a personal loan for that lender.
Lenders offerings risk-based interest rates will be advertised using a range, for example, 7-18% p.a., and you can be approved for an interest rate between that range. Usually, you can get an estimate of the rate you will receive before you fully apply for a loan and without it affecting your credit score.
Home loan interest rates can also be fixed or variable. Fixed interest rates are guaranteed not to change whereas variable rates may fluctuate.
With home loans, fixed interest rates usually only apply for the initial stage of a loan, for example five years. Variable home loan interest rates can change quite frequently as they are heavily influenced by factors in the market, especially the RBA Cash Rate.
The interest you are charged will generally be calculated daily. Home loans can also either be principal and interest, meaning you're repaying both the interest you're being charged and the original amount you borrowed, or interest-only, so you are only repaying the interest accruing on your debt.
Savings accounts work differently from credit accounts because the interest rates earn you money rather than cost you money.
All savings accounts come with a variable base rate, with most calculated daily on your principal balance and paid into your account monthly.
This is referred to as compound interest: the interest repayments you earn then go on to earn interest themselves.
Some savings accounts can also offer you bonus interest on top of the standard base variable rate.
This may be for an introductory period, such as for the first 3 months after opening the account, or applied monthly if you meet certain conditions, such as regularly depositing money into the account.
Keep the following in mind when comparing interest rates:
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