Understanding interest rates for savings

What are interest rates?

When you put money into a savings account, you effectively loan that money to the bank or building society. 

Just as you pay interest to borrow money via a personal loan or credit card, your savings account provider pays you interest in return for the money you are lending them. The interest they pay is expressed as a percentage of the amount in your account, otherwise known as the interest rate.

This arrangement doesn’t mean you’ll notice them borrowing against your balance or should ever be left unable to withdraw your money from an instant access account. 

However, it is why notice accounts and fixed-rate accounts with terms of a year or more often offer higher interest rates – because they give the account provider more flexibility to invest the money in your account.

How do savings interest rates work?

The higher your savings interest rate, the larger the return you should receive on your money – although the total return you receive will also depend on factors such as whether the interest rate is fixed or variable and whether you face any charges or penalties due to your management of the account.

For example, if you invest £1,000 in a savings account paying a fixed rate of 2%, you will earn £20 in interest a year  (or a bit more, thanks to the effects of compound interest). 

But if you invest the same amount in an account paying 7% fixed, your annual return will be around £70.

How do interest rates change?

Banks and other account providers raise or reduce their rates based on various factors, including:

• The savings market (how much interest rival account providers are paying) 

• Their desire to attract new money into their accounts

• The base rate – a central interest rate set by the Bank of England 

The base rate is the main driving force in dictating the interest rates advertised across the savings market.

If the base rate goes up, it’s likely to increase both the cost of borrowing money and the return savers can get on their nest egg. 

If it goes down, savings interest rates will often fall similarly.

Will you benefit from rising interest rates?

If you invest money in a savings account that pays a variable interest rate, you will earn a higher return on your savings if the account provider increases the interest rate – or Annual Equivalent Rate (AER) – paid on the account. 

And as most banks and building societies tend to set their rates more or less in line with the Bank of England's base rate, you will often benefit from a rising rate environment. 

This is particularly true if you invest in a savings account with an interest rate that tracks the Bank of England’s. 

Savvy savers also know that an increase in the base rate pushes up the savings market in general, meaning they can take advantage of better offers – either by switching accounts or simply opening a new one – should their existing account fail to keep pace.

How is interest paid on your savings account?

Different savings accounts pay interest in different ways. You generally earn interest every day your money is invested in the account, but while some accounts pay interest monthly, others only make one annual interest payment. 

Either way, the fact that you are earning daily interest should enable you to benefit from compound interest, which is interest earned on the interest you’ve already earned. 

Compound interest is included when calculating the AERs on savings accounts. However, you should contact your account provider if you have any questions about how interest is paid on your account.

How can you get the best savings rate?

The best home for your savings will depend on several factors, including how much you have to save and when you need it, as well as the interest rate.

So, when it comes to seeking out the best savings rate, you must first decide which type of account best suits your needs.

If, for example, you have a lump sum to invest and don’t expect to need to dip into your savings for a year or more, you can often earn a higher interest rate by choosing a fixed-rate bond rather than a standard easy-access savings account.

If, on the other hand, you are just starting your savings journey or are saving towards a short-term goal, you may be better off with a regular savings account that pays a higher rate in return for regular monthly deposits for a set period of, say, one or two years.

And if you are a top-rate taxpayer or earn a lot in savings interest, your best choice could be a cash ISA that allows you to earn interest tax free. 

Whatever type of account you choose, shopping around for the best deal is vital. Be prepared to vote with your feet and switch accounts to earn the highest possible interest rate on your savings pot. Just ensure you know about any penalties you may trigger if you move your money.