Interest is the price of money over time. It is what a borrower pays and a lender earns for the use of cash, usually quoted as a percentage rate per year.
You will see interest on savings accounts, bonds and cash balances as income, and on mortgages, credit lines and margin loans as a charge. Rates can be fixed or variable, simple or compounded, and they accrue over specific day counts set by market practice.
Simple and compound interest, with quick maths
Simple interest applies one rate to the original principal only. If you lend £1,000 at 5 per cent simple interest for three years, the charge is £1,000 × 0.05 × 3 = £150. The balance after three years is £1,150.
Compound interest applies the rate to a growing base as previous interest is added to principal. Using the same example with annual compounding, the balance is £1,000 × (1.05)^3 = £1,157.63, so the interest earned is £157.63. The more often it compounds, the higher the effective return or cost: annual, semi-annual, monthly or daily. The effect is small over short horizons and modest rates but becomes meaningful over long periods.
You will also meet headline and effective rates. APR is a common borrowing figure that tries to fold fees into a single annual rate for comparison. For savings, banks often quote an effective annual rate that reflects compounding across the year. Naming conventions and what must be included vary by country and product, so always check how the figure is built.
Who sets rates and why they move
At the short end of the curve, central banks steer interest rates through a policy rate and liquidity tools. Institutions such as the Federal Reserve and the ECB adjust settings to balance growth and price stability. Commercial banks then set deposit and lending rates off those anchors, plus a margin that covers funding costs and risk.
Market rates also reflect expectations. If traders think policy will rise, short-dated yields tend to lift in advance. Longer maturities bake in views about future rates, economic growth and risk appetite. Credit spreads add a borrower’s specific risk on top of the so-called risk-free curve.
Inflation matters because lenders want to be compensated for the erosion of purchasing power. Higher expected inflation usually pushes up nominal interest rates, all else equal, while falling inflation expectations pull them down. See our explainer on inflation for how this feeds into real returns.
Where you see interest in trading and investing
- Savings and cash balances: Banks and some brokers pay interest on cash. The rate often lags policy moves and may have tiers or caps. Exact treatment varies by provider.
- Loans and margin: Borrowing against securities incurs interest that accrues daily and is charged monthly. The rate can be fixed for a term or floating over a base rate plus a spread. Short selling can involve a borrow fee that acts like interest for accessing hard-to-borrow shares.
- Bonds: A bond’s coupon is periodic interest on face value. Between coupon dates, accrued interest builds each day so that buyers compensate sellers for the earned portion. Yield to maturity expresses the bond’s overall return as a single rate that blends coupons, price and time.
- Derivatives and carry: Futures prices on financial assets incorporate the cost of carry, which includes interest on cash tied up until expiry, net of any income the asset pays. Options pricing also embeds interest through put-call parity, though the effect is often smaller than volatility and time. In some crypto markets, perpetual swaps use a funding rate that periodically transfers value between longs and shorts to keep prices near spot. The mechanism is interest-like even though it is not quoted as a standard deposit or loan rate.
Nominal, real and effective rates
Nominal interest is the sticker rate you see quoted. Real interest adjusts for inflation to show how your spending power changes. A simple shortcut is real rate ≈ nominal rate minus inflation. If a deposit pays 3 per cent and inflation runs at 2 per cent, the real return is about 1 per cent before taxes and fees. If inflation is higher than the nominal rate, the real return is negative even though the pound amount grows.
Effective rates capture compounding. A 6 per cent nominal rate that compounds monthly has an effective annual rate above 6 per cent because each month’s interest earns a little more interest thereafter. When comparing products, align on compounding frequency to avoid a like-for-unlike comparison.
Fixed versus variable, day counts and other mechanics
Fixed rate: The rate is set for a defined period. Predictable, but you will not benefit if market rates fall unless you refinance and pay any costs.
Variable or floating rate: The rate tracks a reference such as a base rate or interbank benchmark plus a margin. Payments change as the benchmark moves. Lenders may include floors or caps that limit how far the rate can shift.
Accrual and day count: Interest accrues over days using a convention such as actual/365 or 30/360. Conventions differ by market and product and can affect the pennies on each payment. Bond markets, loans and derivatives may use different standards, so read the terms.
Payment schedules: Interest can be paid monthly, quarterly, semi-annually or at maturity. Zero-coupon bonds, for example, pay no periodic interest but are issued at a discount and accrete to par, which is interest in economic form.
Worked examples you can sanity check
Deposit with monthly compounding: You place £5,000 in a savings account at 4 per cent per year, compounded monthly. The monthly rate is 0.04 ÷ 12. After one year the balance is £5,000 × (1 + 0.04 ÷ 12)^{12} ≈ £5,204.07. Effective annual rate is about 4.07 per cent.
Bond purchase between coupons: A bond with a 6 per cent coupon pays £3 every half year on £100 face value. You buy 50 days after the last coupon on a 30/360 schedule. Accrued interest equals 50 ÷ 180 × £3 = £0.8333 per £100. You compensate the seller for that amount at settlement, then receive the full next coupon.
Margin interest on a trade: You borrow £10,000 to increase position size at a stated 8 per cent per year, charged daily on actual/365. The daily rate is 0.08 ÷ 365. A 10-day hold racks up roughly £21.92 in interest before fees and taxes.
Pitfalls and how to read the small print
- Compounding cuts both ways: It boosts savings but also magnifies borrowing costs when interest is added to the balance.
- Headline rates can mislead: Teaser rates, fees and compounding frequency can change the effective rate meaningfully. Match the definitions before comparing offers.
- Variable-rate risk: Payments can rise when the benchmark lifts. Consider whether a cap or a fixed period suits your risk tolerance.
- Taxes and deductibility: Tax treatment of interest income and expense differs by jurisdiction and can change. Check current rules that apply to you.
- Negative and very low rates: In rare cases, nominal rates can be near zero or negative. This can flip familiar assumptions about cash, bond pricing and funding costs.
Interest looks simple on the surface, yet small details such as compounding, timing, day count and benchmark choices can shift outcomes. In markets, it is not only what you earn or pay on cash. It also flows into bond values, futures pricing, option parity and the discounting of any stream of cash flows.