Understanding Interest Rates

Introduction - for many small business owners and individuals, interest rates can sometimes be confusing and difficult to calculate. There are various different measures of interest rates which use different measures of calculation from one another. Financial services organisations have presented commercial offers in their best light using interest rates. Some would say exploiting people's apathy to learn or ability to unravel complicated calculations.

Types of Interest - the main types of interest calculations are as follows:-

• Annual Equivalent Rate (AER) - this is normally used when advertising savings rates. It is expressed as a percentage and shows the total cost over a period of one year. In other words, at the end of one year, if the rate was added to a savings account it would show the interest accumulated as a percentage. He is sometimes expressed on a monthly or quarterly basis to promote the benefits of compound interest. In other words, the longer saver remains loyal to the lender the more they can see the effect of an annual equivalent rate increase on their savings.

• The Annual Percentage Rate (APR) - this is the rate of interest on borrowed money. It is an average interest over the loan or mortgage term and includes any discounts all fees. Personal loans companies use APR to advertise the overall cost of the loan. Typically payments monthly and are paid between three and five years. Normally the shorter the period the higher the APR. Credit card companies also use APR is that calculate on a monthly balances. This means that if the borrower fails to pay the full amount of the outstanding balance of the end of each month, the balance carried forward is charged at a high APR rate, relative to ordinary forms of borrowing. Of course credit cards are a convenient way of life for most people. They have become a major cause of their problems and has led to thousands of personal insolvencies. By translating the monthly APR into an annual APR, it can be shown that credit card interest is extremely high relative to other forms of borrowing. When APR is applied to an overdraft rates is important to identify the differences between authorised borrowing and unauthorised borrowing, which range between 12% APR for authorised and 25% APR for unauthorised borrowing. In addition, banks tend to add on fixed penalty charges for an authorised borrowing on top of an APR. Always check the small print as a minor overspends on any overdraft limit or a late credit card repayment of just a couple of days, could make matters a lot worse.

• Standard Variable Rate (SVR) - this is a great associated with mortgages are not special offers or deals. For instance, discounted mortgages revert to a SVR when they come off their special offer period. The standard variable rate offered by banks and mortgage lenders differs from the base rate set at the monetary policy committee at the Bank of England. All UK lenders use the Base Rate as a basis for setting their standard variable rate when advertising mortgage products and other secured loans. Their standard variable rates will be slightly higher than the base rate to reflect their profit margins. In addition, lenders will look at the inter-banking interest rates or LIBOR which is the cost at which banks lend to each other. It is come huge problem since the credit crunch emerged as banks have become scared to lend to each other causing a shortage of money supply in the economy. This fear is reflected in the increased interest rate between banks.

The Monetary Policy Committee - one of the first policy decisions by the Labour government when they first came into power was to pass control of interest rates setting from central government to a committee of nine economists called the Monetary Policy Committee (MPC). Five members are appointed by the Bank of England and fall external members are appointed by the Chancellor. The committee meets on a monthly basis and is chaired by the Governor of the Bank of England. The underlying objective of the committee is to set interest rates at which the bank of England lenders to financial institutions, in order to meet the government set inflation target of 2% per annum. The in other words it is attempting to deliver price stability and relatively low inflation at a predictable rate. The basic principle of inflation is that it occurs when output volume exceeds output produced. It is tasked at setting rates that considers the unemployment and output rates of the wider economy to ensure stability and growth. By considering these factors, it is attempting to influence the overall level of expenditure in the economy. Their job is to forecast and predict what might happen should rates be set at higher or lower levels. These predictions involve looking at national growth rates, consumer spending, party prices and currency fluctuations.

As the MPC is independent of interference from the government of the day, in theory their decisions are not politically motivated. There are factors outside the MPC's control which have an impact on national inflation. These are most notably the global oil price and inflationary pressures from food and commodities which impact on UK imports, consumer spending, business debt and savings levels. The collapse of property markets in Western economies, the fall in business confidence around the world as a result of the fallout of a credit crunch is making the MPC is job very difficult. On one hand it is trying to stimulator growth and prevent recession by low interest rates, on the other hand non-UK pressures are causing inflation to rise to 5% which would normally mean an increase in rates to dampen down inflation. A reduction in interest rates means their borrowing rates become more attractive which in turn stimulates business investment and consumer spending. An increase in interest rates has the opposite effect. When deciding what interest rate to set, the committee's remit is to look at the long-term inflation rate over a number of years.