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What are Interest Rates and Why Do They Matter?
Most people have heard of interest rates and the vast majority of people pay interest on mortgages, loans, and credit cards. However, the complexities surrounding how rates are set and how they’re applied mean that many people are unaware of the rationale behind them.
Despite this, interest rates have a major impact on your finances, which means it’s important to know a little more about them. Read on to find out everything you need to know about interest rates and why they matter.
What Is an Interest Rate?
When you borrow money from a commercial lender, such as a bank, you’re required to pay it back in full, but you’re also required to pay interest on top. The amount of interest you’ll need to pay will depend on the interest rate you agree to at the outset.
In simplistic terms, if you take out a loan of £5,000, for example, and you agree to an interest rate of 5%, you’ll need to pay back the £5,000 you’ve borrowed, plus £250 in interest (5% of the loan amount).
However, most lenders charge interest at an annual percentage rate (APR), rather than a one-off percentage. This means that interest is calculated annually, rather than monthly or daily, although payments may be made incrementally throughout the year.
If you take out a loan of £5,000 with an APR of 5% and you pay it back over a 12-month period, the total you’ll pay back is £5,133.40. However, if you borrow the same amount at the same rate and pay it back over a 36-month period, the total you’ll pay back is £5,385.79.
Of course, interest rates don’t just apply when you borrow money. You can earn interest when you put money in a savings account, for example. With an annual interest rate of 2%, you’d earn £2 for every £100 you saved for a 12-month period, providing you didn’t withdraw the funds during this timeframe.
Do Interest Rates Really Have an Impact?
Many people underestimate the impact that interest rates can have on their financial situation, which can lead to money worries and financial difficulties. To get a clearer idea of how interest rates affect your finances in real-life, take a look at the following example:
If you borrow £1,000 over a 12-month period at an APR of 3%, you’ll pay back £1,016.10 in total. However, borrowing the same amount over the same time period at an APR of 5% means you’ll need to pay back £1,026.68 in total, and an APR of 10% means you’ll be paying back £1,052.59.
This may seem like quite a modest increase, but when you think about the sums borrowed when mortgaging a property or the high APRs charged by credit card companies, it’s easy to see how a high interest rate can wreak havoc on your finances.
How Are Interest Rates Set?
Commercial lenders set their interest rates based on a number of factors. However, the Bank of England interest rate, sometimes known as the base rate, has a major impact on the interest rates offered by lenders.
This means that the interest rates offered to consumers by lenders are heavily dependent on the Bank of England base rate. By keeping up to date with what the current base rate is and whether it’s likely to change, you can determine whether it’s a good time to borrow and/or save and establish what a competitive high street interest rate is.
What Is the Bank of England Interest Rate?
Banks and building societies borrow and save money from the Bank of England, which operates as the Central Bank of the United Kingdom. These banks and building societies pay interest to the Bank of England on money they borrow from it and earn interest on the money they save with it. The interest rate set by the Bank of England determines how much a high street bank of building society will need to pay back when they borrow money or how much they’ll earn when they save money.
The Bank of England’s Interest Rate (base rate) is set by their Monetary Policy Committee (MPC) and is designed to keep inflation low. If inflation is too high, it lowers the value of money, which isn’t good for individuals or the economy as a whole. The cost of goods, including food and fuel, increases when inflation is high, which means your money doesn’t go as far.
Conversely, when inflation is too low, people are often reluctant to spend their money because they want to wait and see if prices will drop any further. This can have a negative impact on the economy, which is why it’s so important that inflation remains at an acceptable and appropriate level.
The Bank of England sets its base rate accordingly, which helps to keep the country’s economy stable and protects the value of the pound.
How Does the Bank of England Interest Rate Affect Mortgages?
High street banks and building societies set out to make a profit. If they borrow money from the BoE at 1% but then allow customers to borrow from them at 0.5%, they will lose money. In contrast, if a high street bank borrows money from the Bank of England at an interest rate of 1% and then lends it to customers at a 2% interest rate, they make a profit.
Essentially, commercial lenders adjust their interest rates depending on the base rate so that they always make a profit. Although other factors, such as your credit score, affect the interest rate you’ll be offered on a mortgage, the Bank of England base rate will always have a significant impact on the interest rate you’ll be offered on a mortgage or loan.
If the Bank of England base rate is low, for example, mortgage interest rates might drop too. If the Bank of England base rate is high, you can expect mortgage interest rates to increase accordingly.
Although this is relevant when you’re taking out a mortgage or remortgaging a property, it’s also relevant if you have an existing mortgage. If you have a variable interest rate mortgage, for example, any change to the Bank of England base rate will have an immediate impact on your repayments. Alternatively, if you have a fixed rate mortgage and the base rate changes just before you’re due to renew your rate, the interest rates you’re offered will depend on how the base rate has changed.
How Often Does the Bank of England Change Interest Rates?
The Monetary Policy Committee meets approximately every six weeks to discuss the Bank of England interest rate. However, it does not usually change the base rate at every meeting. It can be difficult to predict exactly when the base rate will be changed but it rarely comes as a total surprise. Instead, the Bank of England issues guidance in advance, which helps people to determine whether the interest rate is likely to rise or fall in the foreseeable future.
When Is the Bank of England Interest Rate Reviewed?
The Bank of England base rate is officially reviewed by the MPC every six weeks. In reality, however, experts are constantly assessing economic conditions with a view to changing the Bank of England interest rate, if it’s required.
In the event of a sudden economic event, the Bank of England base rate could be changed without warning. However, this is an extremely rare occurrence and most changes to the base rate are known about in advance.
Is the Bank of England Going to Raise Interest Rates?
The Bank of England will raise its base rate in response to economic factors. Due to the COVID-19 pandemic, the base rate was reduced to an all-time low, which means an increase is inevitable at some point in the future. However, that doesn’t necessarily mean that the Bank of England interest rate will increase straight away. In fact, the Bank of England has confirmed that they could reduce it further to a 0% or negative base rate if the economic conditions require them to do so.
When Will Bank of England Interest Rates Rise?
The Bank of England base rate will increase in response to economic events, which means it will modify its interest rate to control inflation based on external factors. If spending increases on a national scale, for example, the base rate is likely to rise once again.
Fortunately, most base rate increases are publicised beforehand, which enables consumers to make informed financial decisions.
Is the Bank of England Interest Rate the Only Factor That Affects Mortgage Rates?
No. Although the Bank of England interest rate has a substantial impact on mortgage rates, it isn’t the only factor that’s taken into account when commercial lenders set their interest rates. Lenders want to charge high interest rates to borrowers and give low interest rates to savers, as this enables them to make more profit. However, they need to be competitive in order to keep customers. This means that high street banks and building societies will try and offer the best rates to consumers, in a bid to attract more customers.
In addition to this, your own financial history and current circumstances have an impact on what interest rates you’re offered when you borrow money. If you have a low credit score, for example, banks will see you as a ‘risky borrower’, which means you’re likely to be offered a higher interest rate. Conversely, if you have a good credit history, you may be seen as a low-risk borrower and be offered a lower interest rate.
While some factors, such as the Bank of England base rate, are out of your control, this doesn’t mean that you can’t change the interest rates you’re offered as a borrower or as a saver. By shopping around and finding the best deals from banks and building societies, and maintaining a good credit score, you can ensure that you’re offered the best interest rates available.