Loans and Savings
Our page on Understanding Interest explains the basics about how to calculate interest, especially compound interest.
This page puts that into a bit more context, explaining the link between savings and loans, and how banks use money.
It also explains some of the principles behind banking, such as why loans will cost more if you will find it harder to repay the money.
If you put your money in a savings account, it doesn’t just sit in your account doing nothing.
The bank is able to use it to lend to other people, and to invest in businesses. Astonishingly, a bank can actually lend your money about ten times over. This means that each £1 deposited with a bank is worth about £10 in loans.
A Run on the Bank
If a bank gets into financial trouble, savers may try to withdraw their savings. This can lead to a ‘run’ on the bank, which is what was seen with Washington Mutual in the US and Northern Rock in the UK, where all the savers try to withdraw their money at once.
As banks lend out the money about ten times over, you will understand that at any given time, the bank is unlikely to have enough cash to pay back every saver. A run on the bank can therefore be a disaster, leading to the bank going bust.
Because banks can lend your savings to other people, they are able to earn money on them. This means that they can give you money as a reward for giving them the use of your money. This is the interest.
The interest rate paid depends on what banks think they can earn on the money. So, for example, if you are prepared to promise to leave your money with the bank for several years (a fixed term savings account), then you will get a better rate of interest than if you want instant access to your money. The longer the fixed term, the better the interest rate.
The interest on savings accounts is usually paid either monthly or yearly. In the UK, banks are obliged to quote both the rate and period at which the money is added, and also an annual equivalent rate, or AER, for monthly savings accounts. This is to allow easy comparisons between two accounts offering different interest periods.
Net and gross interest
In the UK, tax is paid at basic rate and at source on the interest on savings accounts. You will therefore see both net and gross interest rates. Gross is the total interest, and net is what you get after you have paid the tax due.
If you are a non-taxpayer, you should always tell the bank, so that the tax is not deducted from the interest paid.
Banks are Businesses
Banks need to make a profit, like any other business. People sometimes make the mistake of thinking that their bank wants the best for their customers. As a general rule, they don’t. They want the best for their shareholders, which may involve paying customers less than customers would like.
It is therefore worth keeping an eye out for:
- Bank accounts which only pay interest if you leave the money there for a full term, usually a year, and may pay no interest if you withdraw the money even one day early;
- Bank accounts which pay their best rate of interest if you keep a certain amount in the account, often £5,000 or £10,000, with the rate for sums below that being negligible;
- Bank accounts whose interest rate drops dramatically after a fixed period, again often a year; and
- Bank accounts which pay an ‘introductory bonus’ for a period, after which the interest rate drops severely.
If you find that you have a savings account which is not working for you, it’s best to change to a different one, whether with the same provider or another. You can find tables of ‘best buys’ on various websites and in the press to enable you to compare.
The other side of the coin, and the way that banks use the money from savers, is to provide loans to individuals and businesses.
There are a number of different types of loans and also of loan providers. However, what they all have in common is that you are almost invariably charged, often heavily, for the use of the money.
The exact interest rate depends on the size of the loan, the repayment period, and also the security of the loan. Security means how likely you are to pay back the money, and/or how easily the bank can recover its losses.
Secured and Unsecured Loans
Secured loans are those which are guaranteed in some way.
Secured loans include mortgages, which are usually very long term (15 to 25 years), and where you guarantee the loan against the property. If you default on the loan, the mortgage provider can force the sale of the property to recover their money.
Other secured loans include ones that are personally guaranteed, where someone agrees to repay the loan if you default. In general, lenders use secured loans for large sums of money, or ones that are a bad risk, that is, where they think they may struggle to get the loan repaid.
It is a very bad principle to agree to guarantee anyone else’s loans, whether an individual or a business, because it can lead to you losing your home and/or all your money.
Think very carefully before you agree to anything that requires you to act as a ‘personal guarantor’.
Unsecured loans include standard bank loans, loans from so-called ‘pay-day’ lenders, and loans from dedicated loan companies.
In general, the more you need to borrow money and the harder you will find it to pay back the loan, the higher the interest rate.
This is because lenders are trying to protect themselves against the risk that you will default by charging a high interest rate, so that they make a return on the money.
While borrowing money is sometimes unavoidable, it is wise to be certain that you will be able to pay it back once the loan falls due. Otherwise, the interest rate is likely to be punitive in the extreme, and you may find that you owe many times the original amount of the loan in a fairly short space of time.
Credit cards: an expensive way to borrow money
You can consider credit cards as a way to borrow money. They effectively act as a short-term loan.
When you spend using a credit card, the credit company (your card provider) pays and then charges you later. There is a grace period, usually up to one month, until you receive a bill, during which you are charged no interest. You then have a certain length of time until you have to pay the bill to avoid incurring interest charges.
Credit cards are fine if you pay them off in full each month. Then there is no cost to borrowing.
However if you don’t pay them off in full, the interest rates tend to be high, often as much as 15% or 20% of the value of the loan. And because this is compound interest, it quickly mounts up into serious sums of money.
See our page, Understanding Interest for examples of how compound interest works.
Credit cards, like other short-term loans that are not repaid quickly, are therefore an expensive way to borrow money, and should not be considered a long-term financing option.
There may well be times when you can afford to save, and times when you need to borrow money.
This page should help you understand the options available to you and, with our page on Understanding Interest, help you to compare like with like. It may also help you to see why advice from banks and other lenders is not necessarily always in your best interests.