Everything you need to know about interest rates

Published by Rachel Lacey on 03 July 2014.
Last updated on 04 July 2014

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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.

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Controlling inflation

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."


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