Everything you need to know about interest rates
It can help you decide whether to go for a fixed rate on your savings or mortgage and will give you a better understanding of why rates will change on those products if you opt for a variable rate. By gaining an understanding of how interest rates work you are better able to assess the risks associated with the option you eventually choose.
The UK's interest rate - which is effectively the price of borrowing at any one time - is set every month by the Monetary Policy Committee at The Bank of England and therefore influences rates for both mortgages and savings accounts. If the base rate rises, the cost of borrowing will rise, as will the amount you receive back on any savings you 'lend' to your bank or building society.
By the same token if the base rate falls, then the level of interest you pay on your mortgage should fall, as well as the amount you earn on your savings (unless of course you have a fixed-rate product, in which case your rate will remain stable irrespective of what is happening to the bank base rate).
Likewise it also affects the price of other assets including shares and bonds as well as the exchange rate.
But what economic factors drive interest rates? "The main factor is inflation," explains Laith Khalaf, head of corporate research at Hargreaves Lansdown. "The bank's mandate is to keep inflation under control, which means keeping the consumer prices index (CPI) at 2%."
The MPC's key tool for controlling inflation is setting interest rates, which allows it to take control over levels of spending in the economy. "If borrowing is cheaper people will spend and businesses will spend and invest and that, in theory, leads to price rises and inflation," he adds. But if borrowing is expensive, our spending will be curtailed and inflation will fall.
So in very crude terms: if inflation exceeds its target, interest rates will rise to curb spending, and if inflation is below its target rates will fall to take the brakes off spending. But of course the reality isn't quite so simple – particularly in the wake of the financial crisis which saw interest rates plummet from 5% in October 2008 to 0.5% by the following March.
Other factors the MPC will take into account are GDP – growth in the UK's economic output – as well as trade figures, wage growth and employment data. As Khalaf says: "One single figure in isolation doesn't tell the whole story."
Indeed if inflation had been the only factor to take into account, the base rate would not have rested at its historic low of 0.5% for nearly so long. Subdued wage growth meant people's incomes had been falling in real terms and so spending had been reined in despite the persistently low rate. "It means the Bank of England was happier keeping interest rates lower. It might not have been so sanguine if wage growth had been higher," says Khalaf.
Likewise, back in August 2013, Mark Carney, governor of the Bank of England announced a policy of 'Forward Guidance' to provide consumers and the markets with a clearer idea as to when the interest rate would eventually rise. At the time Carney said the rate would not rise until unemployment had fallen to 7%; however, as the unemployment rate proceeded to fall faster than anticipated, the policy was reviewed six months later and Carney has said that he would no longer use this single piece of data as a guide.
At the time of writing views were mixed as to when interest rates would rise from their historic low. The expectation from the markets was that rates would not start to rise until mid-2015, however recent comments from Carney suggest that rates could now rise before the end of 2014 as the economy continues to strengthen.
"This is a balancing act," says Khalaf. "The Bank of England is looking at the UK recovery – if it makes the decision to increase rates too early it could stifle the recovery. If it leaves it too late inflation could spiral out of control."
How rate rises will affect you depends on what mortgage and savings products you have or plan to buy.
If you have a fixed-rate mortgage you can be confident that your repayments will not rise until your deal expires. If, on the other hand, you have a tracker mortgage which is directly pegged to bank base rate you can be certain that it will rise and you'll know by how much. Borrowers with variable rate mortgages – or who are paying their lender's standard variable rate – can also expect rates to rise. However, because rate changes are down to the discretion of the lender there is no certainty as to what the rate rise will actually be.
For those shopping around for new mortgages, it pays to know that there are factors other than base rate that will influence the cost of your borrowing – most notably the cost of funding the loans.
David Hollingworth, head of communications at mortgage broker London & Country says this is why there can be a lot of fluctuation in the price of fixed rate mortgages despite interest rates remaining steady - their cost is based on swap rates which reflect market expectations of where rates will go. So even though interest rates have not moved for more than five years, "five-year fixes are now 0.5% higher than they were 12 months ago," he says.
The higher cost of funds also explains why mortgage rates didn't fall nearly as much as borrowers might have expected when interest rates plummeted to 0.5%. "Historically a lender's SVR would be around 2% over base rate but now they can 3.5%- 5.5% above base rate," adds Hollingworth.
When interest rates rise, savers should theoretically enjoy higher rates but again this will be down to the bank or building society's discretion. Sue Hannums, spokesperson for savings advice site savingschampion.co.uk warns that savers should not expect to reap the full benefit of any rate rises. "There has been little correlation between savings rates and base rate for some time now, with thousands of existing savings rates being cut even with no movement in the base rate for over five years."
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.
Every mortgage lender has a standard variable rate of interest, or SVR, on which it bases all its mortgage deals, including fixed and discounted rate and tracker mortgages. When special deals come to an end, the terms of the deal usually state that the borrower has to pay the lender’s SVR for a period of time or pay redemption penalties. The lender’s SVR is, in turn, based on the Bank of England’s base lending rate decided by the Bank’s Monetary Policy Committee (MPC). Every time the MPC raises its rate, mortgage lenders generally increase their SVR by the same amount but when the MPC lowers its rate, lenders are often slow to pass this on or don’t pass on the full cut to borrowers.
With a tracker mortgage, the interest you pay is an agreed percentage above the Bank of England’s base rate. As the base rate rises and falls, your tracker will track these changes, and so rise and fall accordingly. If your tracker mortgage is Bank of England base rate +1% and the base rate is 5.75%, you will be paying 6.75%. Tracker rates are lower than lender’s standard variable rate (SVR) and as they are simple products for lenders to design, they usually come with lower fees than other mortgage schemes.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The total money value of all the finished goods and services produced in an economy in one year. It includes all consumer and government consumption, government spending and borrowing, investments and exports (minus imports) and is taken as a guide to a nation’s economic health and financial well being. However, some economists feel GDP is inaccurate because it fails to measure the changes in a nation's standard of living, unpaid labour, savings and inflationary price changes (such as housing booms and stockmarket increases).
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.