What are interest rates?

Interest rates indicate the cost of borrowing money or how much you earn by saving, based on a percentage of the amount involved. Understanding how interest works can help you make informed decisions when shopping around for the best deal on a bank loan or savings account. Here, we look at different types of interest rates, the various factors that influence them, and how to compare savings accounts with different interest rates.

The information provided here is for informational and educational purposes only and does not constitute financial advice. Please consult with a licensed financial adviser or professional before making any financial decisions. Your financial situation is unique, and the information provided may not be suitable for your specific circumstances. We are not liable for any financial decisions or actions you take based on this information.

An interest rate can be defined as either the percentage you earn from the money you’ve saved, or the percentage you’re charged for the money you’ve borrowed.

Interest rates are usually expressed as an annual percentage of the original amount, but they can be calculated over shorter periods. They vary depending on the financial provider and the type of financial product you choose, as well as various other factors.

Interest rates can change in line with changes to the European Central Bank (ECB) base rate (also known as the bank rate), impacting both borrowers and savers. If the ECB base rate goes up, the cost of borrowing will probably increase, but savers might earn more on their deposits. There are countless other factors that could influence banks to change their interest rates, including changes in demand and the interest rates offered by other banks.

Learn more in our guide to ECB interest rates.

Interest rates and inflation go hand in hand, so when one moves, the other usually follows suit. A rise in interest rates means inflation often eases. This is because borrowing money becomes dearer, which tends to result in people (and businesses) holding back on spending. In turn, prices don’t rise as quickly, which helps to curb inflation.

Falling interest rates mean that saving isn’t as attractive as before but loans are cheaper. People might be more likely to take out a mortgage or credit for a major purchase, and businesses might invest more. That extra spending can push prices up, thereby fueling inflation.

That’s why the ECB adjusts interest rates, because their goal is to keep inflation on an even keel. Raising the base rate can help ease activity in the economy when prices are rising too quickly, while lowering it can give the economy a boost when it’s stagnating.

Because inflation can lower the value of your savings as the years go by, it can help to learn how to protect savings from inflation.

There are two main types of interest rates; the simple interest rate and the effective interest rate (typically referred to as AER).

The simple interest rate is defined as the percentage used to calculate how much interest you’ll earn or owe on a fixed sum of money over a set period of time. It only applies to the original amount (the principal), not to any interest that builds up over time.

The simple interest rate can be broken down into the nominal interest rate and the real interest rate. The nominal interest rate is the given rate on which interest payments are calculated or the rate on which savings earn interest over time. 

The formula for nominal interest is Principal × Rate × Time. For example, a deposit of €10,000 at a nominal interest rate of 2% over one year would earn you interest of €200.

The real interest rate takes the impact of inflation into account by deducting the rate of inflation from the nominal interest rate. For example, if the nominal interest rate is 2% and the inflation rate is also 2%, the real interest rate is 0%.

The AER (Annual Equivalent Rate) is a way of illustrating the interest rates of savings accounts in Europe. It shows how much you could earn from a savings account if the interest was calculated daily, compounded annually, and paid after 12 months. The AER is an illustration of how much you could expect to earn per year and makes it easier to compare savings accounts.

APR stands for Annual Percentage Rate. APR is the interest rate displayed when borrowing money, showing the total cost of a loan or credit over the course of a year, including most fees incurred. Just like the AER for savings accounts, the APR is useful because it sets a comparison benchmark for loans and credit products, including personal loans, mortgages, car loans, and credit cards.

Negative interest rates can be used to stimulate economic growth by making it cheaper to borrow money in order to increase spending and investment. Central banks set rates below zero to make saving less attractive and encourage borrowing instead.

Different interest rates exist as some are better suited to specific financial products than others. As well as the ECB’s base rate, factors that determine the interest rates offered by financial providers include the following:

• The type of savings account
• The residual term of a loan or investment 
• The currency of the account
• The number of commercial banks in the country
• National projections of savings vs credit
• The risk to the bank

The main difference is in how the interest rates work, i.e. whether (and how) they might change over the term of a loan or savings account.

Fixed rates of interest allow you to know exactly how much you’ll pay back on a loan or earn from a savings account, and this amount won’t change, even if the ECB base rate changes. For example, with a fixed rate savings account, you can lock your money away for a set period of time at an interest rate that stays the same from the day you open your account until the end of your term. Savings accounts with fixed terms can be preferable during times of uncertainty, as you don’t have to worry about interest rates dropping.

A variable rate of interest allows your financial provider to increase or decrease your interest rate at any time. A financial provider will typically do this in response to a ECB base rate change, but other factors can result in a rate change. For savings accounts with variable interest rates, this means that you could earn more or less from your savings deposits, depending on whether the rate increases or decreases. You can stay prepared by reading about what’s next for interest rates in Ireland.

When it comes to loans, the way you pay interest depends on the type of loan and terms of the lender. How interest is paid on a savings account depends on your savings provider, but it’s usually paid annually. It’s always best to check the details of the savings account you’re applying for, as interest can also be paid quarterly, monthly, or even daily. You’ll typically earn more from a savings account if interest is calculated more frequently due to the effects of compound interest.

If a financial service provider doesn’t use a standardised method when listing interest rates, it can be difficult to compare savings accounts and loans. You can make it easier by making sure you’re looking at the APR on each loan, mortgage, or credit card - or the AER for savings.

For savings accounts, one of the most important things to know is which interest rate a financial service provider is using, i.e. whether it’s the nominal interest rate or the AER. You should also find out how often interest is calculated and whether there are any administrative fees.

AER is typically used to compare the interest rates of savings accounts, as it clearly explains the overall interest you could earn. At Raisin, we use the AER to advertise the interest rates of all savings accounts offered by our partner banks as we believe that it provides you with a clearer understanding of how profitable a savings account is.

Because it’s important to understand what each type of interest rate means when choosing an account, Raisin displays the AER to clearly show how much you could earn. You can use our table of savings accounts to compare and find the most competitive interest rates on savings accounts offered by our partner banks. Interest rates vary by bank and account type.

When you’re ready, just pick the savings account that suits you, simply register for a Raisin Account and log in to apply. Setting up an account is quick, free, and easy.