We regularly hear about interest rates in the media, whether it’s mentioned in newspapers, discussions on the radio or updates on our screens – but are they cause for concern? Although it’s something we hear about a lot, we don’t always know the ‘why’ or ‘how’ behind changes being made that could have a knock-on effect on the economy and most importantly, our personal finances.
You may be wondering what impact the ever-changing interest percentage rate has on you, which is why in this article, we’re going to explore these questions:
- What are interest rates?
- How do they impact your finances?
- What’s the link between interest rates and inflation?
We’re going to break these questions down so that interest rates are easier to understand and to look at how they can affect you. Read on for more.
What are interest rates?
Often referred to as the ‘bank rate’ or ‘base rate,’ the national interest rate is a percentage figure set by the Bank of England that plays a vital role in our economy. This percentage can mean that banks or financial providers change the rates of their mortgages, loans, savings, bank accounts, and so on. This is because it reflects the rate of interest that the Bank of England charges banks and building societies to borrow money. The base rate means that the national interest rate serves as a measure of the cost of borrowing money or the rewards of saving. Therefore, it can impact your finances positively or negatively, depending on how you look at it.
Interest rates for borrowers
Borrowing money, whether from a bank or another type of lender, usually comes with an interest rate. The rate is added to the amount you borrow, meaning you pay back more than you initially take out. This can depend on the terms and conditions you agree to, as how interest is calculated, the repayment schedule, and any additional fees vary. Usually, when you pay the loan off (along with the added interest), interest payments back to the lender stop. Lower interest rates mean a lower cost to borrow money vs higher interest rates. High interest rates can significantly increase the cost of borrowing.
Student loans, home mortgages, and credit cards are common examples of ways people borrow money and how the interest rate on these can impact how much is owed back. Say you borrowed £100,000 from a mortgage provider, and the mortgage interest rate was 5% for a 25-year repayment term, you’d end up paying £175,441 in total. On the other end of the spectrum, if the mortgage interest rate were 2% for the full repayment term, you’d only pay back £127,179 – that’s a difference of £48,262 in comparison with the 5% rate. This calculation includes the amount borrowed and the total interest, however, mortgages can involve additional fees.
Please remember: How much you pay back for a mortgage can change based on various factors such as fees, the mortgage plan and fluctuation in interest rates over the years, as well as the details of the loan. You can use a mortgage calculator or talk to a financial advisor to get a better understanding of the exact details and figures based on your situation.
Interest rates for savers
Looking at it the other way around, if you save your money in a bank, building society or financial institution that offers interest, you can make money from the amount that you deposit. The amount of interest you can earn depends on the interest rate specified by the organisation. For instance, if you deposit £10,000 in an account with a 3% annual interest rate that gets paid at the end of the year, assuming the rate stays the same, you will have £10,300 after the year once the interest is added on. This nets you an extra £300 on top of your original deposit.
Do keep in mind, however, that the interest you earn may be subject to income tax. For guidance tailored to your situation, always consult the latest tax regulations.
To find out how you can start saving, view our investment products page.
Remember: When you invest, your capital is at risk.
Interest rates explained
The Bank of England is the central bank, separate from the government, that reviews interest rates monthly and updates the percentage based on the economy. Their website states they set the ‘Bank Rate to influence other interest rates. We use our influence to keep inflation low and stable’.
Numerous factors across the world and within the economy can trigger the increase or decrease of interest rates, such as:
- Inflation – Generally, when inflation is high, suggesting that the purchasing power of money is falling, the Bank of England are more likely to raise interest rates. This helps to curb spending and borrowing to slow down inflation and is usually the key lever in controlling inflation.
- Economic growth or recession – If the economy is doing well, central banks may raise interest rates to reduce the risk of inflation. On the other hand, if the economy is suffering, then interest rates typically fall to encourage economic growth. Interest rates can be changed based on future predictions and expectations to help the economy.
- Policy goals – There are target interest and inflation percentages that the government and Bank of England aim to achieve.
- World events – some recent examples of events that have influenced interest rates include the COVID-19 pandemic, the Russia-Ukranian War, and the cost of living crisis. Events that influence global commodity prices and trade can shake economic confidence and stability, prompting changes in policies to try to help restore balance.
- Supply and demand – looking at it in more detail, if the demand for borrowing is higher, this could result in raising the interest rates for moneylenders, and vice versa if lower.
The Bank of England interest rate is implemented as soon as it is announced, and then individual banks or lenders can change and set their rates in response to this. The timing and extent of these adjustments can vary, if any, as each institution decides how and when to react to the national rate changes.
How do interest rates affect inflation?
Interest rates are adjusted based on the current rate of inflation. The goal with this is to reduce inflation if it’s higher than what the government aims for, which is currently around 2%. High inflation can harm the country’s economy in many ways, so the government wants to prevent this when possible.
Higher interest rates are often set to lower spending in a bid to lower inflation and help the overall economy. Essentially, higher interest rates mean the cost of borrowing and spending rises, which in turn decreases these activities. The reduced demand that results from this is expected to slow down inflation.
When inflation is high, it can increase national living costs, reduce the value of money, create uncertainty in the economy, and negatively impact people’s saving and investment returns. These issues can slow economic growth and create challenges for households and businesses.
Therefore, to control high inflation, higher interest rates may be introduced. By making borrowing more expensive, people and businesses are less likely to borrow and spend. This reduction in spending should, in theory, lead to lower demand for goods and services, which can help slow down inflation.
How do interest rates affect my personal finances?
Interest rates can have an impact on any loans, borrowing, investments, and savings you may have. Not only this, but the rate dictates how much bank loan money is circulating in the economy, which can slow down consumer spending. This is intended to prevent prices from rising too quickly, helping to control inflation.
When interest rates rise, it’s positive for savers but negative for borrowers. The exact impact on your finances depends on whether you’re saving, borrowing, or investing, and on the terms involved with your provider’s savings accounts, investment plans, loans, and credit products.
Navigating interest rate fluctuations
Although it’s natural to be concerned about how interest rates might impact your finances, rushing into decisions about what to do with your money isn’t advisable. Take the time to thoroughly research your options and consider your financial situation carefully before moving money about. Speaking with a financial advisor can provide valuable insight. By gathering information and seeking professional advice, you can make well-informed decisions when it comes to your finances.
As interest rates can change regularly, whether you’re an investor, saver, or borrower, you should always try to keep your long-term financial goals in sight. Otherwise, you could end up losing out with the fluctuation in rates over time. Ask yourself the following questions when interest rates change:
- What am I saving for?
- What are my financial goals?
- What is my monthly saving budget?
- When and how often do I need to access my money?
With these questions in mind, you can consider what financial product could be best suited to you, to help you to manage your money keeping in mind the interest rates.
Some investment products can shield your money from interest rate volatility, such as a fixed rate bond. If you have your money in a fixed rate bond, this gives you interest on your money for a set period. For example, if you open a five-year fixed rate bond, you deposit a lump sum for five years at the interest rate that was set when you took the plan out. This means that throughout this period, your money is shielded from changes to interest rates, and once your bond has matured after the five year period, you know what returns to expect based on the originally agreed fixed interest rate.
There are advantages to a fixed term investment, as you know what you’ll get out of your investment, so it’s generally considered safe and stable. There are potential drawbacks to this too though, as if interest rates rise during your fixed rate term, then you are missing the opportunity to get more out of your investment. Plus, if inflation goes up, then your investment can lose value.
For medium to long-term investing, you should also consider a Stocks and Shares ISA to give your money the opportunity to grow over time with tax-free returns.
Remember: When you invest, your capital is at risk and you may not get back what you put into your investment.
All in all…
Interest rates play a significant role in your financial life, whether you’re saving, investing, or borrowing. While fluctuations in rates throughout the year are common, large-scale events can lead to more noticeable changes that have a larger impact on the economy. Higher interest rates can benefit savers looking to grow their funds, as it gives them more potential to grow their money. On the flip side, those looking to borrow will find higher rates less desirable, as the cost of borrowing increases, meaning borrowers end up paying more back over time. Understanding how these rates work and their potential impact can help you make more informed financial decisions.