When a product provider quotes an interest rate, it is not always immediately apparent how much you will be paying - or be paid - if you take out the product. When shopping around for savings accounts, for example, different providers may choose to quote monthly or annual interest rates, making it difficult to compare accounts fairly.
When it comes to loans and mortgages, some lenders charge hefty upfront fees, and low interest rates, while others charge low fees and high interest rates.
This is where measures such as the annual equivalent rates (AER) and annual percentage rate (APR) come in handy. These are calculated in the same way across providers. If you are trying to compare accounts, look for these, rather than the headline rate.
Annual percentage rate (APR)
An APR is used as a measure of how much it costs to borrow money and is quoted by mortgage lenders and companies offering personal loans and credit cards. The APR includes any upfront fees charged by the lender, spread over the period for which you are borrowing the money.
The APR tells you how much your borrowing will cost over the course of a year, as a proportion of the amount you have borrowed. So if you are borrowing £100 at an APR of 9%, you will pay £9 in interest and charges over the first year.
In a loan advert, the provider will often quote a "typical APR" - this is because many lenders set the actual interest rate charged according to the borrower's credit record and personal circumstances. A bank has to have offered its typical APR (or a better rate) to at least 66% of potential customers.
In a mortgage advert, the lender will usually quote a headline rate as well as the APR. Most lenders charge administration fees on mortgages, so APRs tend to be much higher than the headline rates.
Equivalent annual rate (EAR)
Like the APR, an EAR is quoted when you are borrowing money - this time in the form of an overdraft. Unlike an APR, this doesn't include any fees for going overdrawn. Instead, it gives you an idea of how much your borrowing will cost if you were to remain overdrawn for a whole year.
The calculations take into account the rate of interest being charged, how often it is charged, and the effect of compounding it - charging interest on interest - over the year.
Annual equivalent rate (AER)
An AER is quoted on savings accounts and current accounts for when your balance is in credit. It is like the EAR but refers to interest earned, rather than paid. The AER shows how much interest you will earn over the course of a year and takes into account how often the interest is paid and what effect compounding will have.
This measure allows you to compare how much you will earn on an account where interest is paid monthly with one where interest is paid annually.
The gross rate paid on an account offering monthly interest may be lower than the gross rate on an account offering only one interest payment a year, but when interest is compounded it may offer higher returns than the latter account.
For example, an account offering a rate of 6.25% paid annually may look more attractive than an account paying 6.12% with monthly interest payments, however the AER on the monthly account is 6.29%, as opposed to an AER of 6.25% on the account with annual interest payments.
If there is a charge for withdrawing your money, the AER will take this into account - so, for example, if you are charged 30 days' interest for a withdrawal, this will be reflected in the AER.
If an account includes an introductory bonus for a few months, you should be told whether or not this is in included in the AER. If it is not, looking at the AER will enable you to compare it fairly with an account that offers a level rate of interest all year.