Back to basics: Interest rates

If you’ve got used to rock-bottom interest rates over the past few years, a rate rise could prove a real shock to your finances.

Bank of England

What better time then, to take some time to understand how interest rates work, who decides them – and what affects that decision?

What are interest rates?

An interest rate is basically the cost of borrowing money, or a reward for lending money.

So, if you borrow £10,000 from a bank, you will have to repay this amount, plus interest. 

If you put savings into a bank, you will earn interest on this money as a reward for keeping it in the bank (which is effectively lending it).

Who sets interest rates?

UK interest rates (also known as ‘base rate’) are set each month by a group known as the Monetary Policy Committee (MPC).

Its nine members consist of Mark Carney, the governor of the Bank of England, two deputy governors, the executive director for markets, the Bank’s chief economist, and four external members who are appointed by the Chancellor of the Exchequer.

How are rates decided?

The MPC’s job is to decide on a rate that will meet the government’s inflation target, which is currently 2%.

“Even though the base rate is at 0.5%, the average mortgage standard variable rate is currently 4.75%, for example. ”

Inflation is the rate at which prices for the goods and services you use go up.

If inflation rates are rising too quickly, then the MPC is likely to raise interest rates to try and slow them, whereas if inflation is very low, interest rates will stay low too. That’s because low interest rates help boost economic growth, as it’s cheaper for businesses to borrow money.

The Bank of England wants to encourage businesses to take on workers, which many can only afford to do when interest rates are low, so rates are also linked to unemployment.

Mark Carney said that the Bank would not raise interest rates from their current low of 0.5% until unemployment had fallen to 7% or below.

The MPC also takes other economic indicators into consideration, including wages and productivity.

When are interest rate decisions made?

The MPC meets monthly for two days, usually on the Wednesday and Thursday after the first Monday of each month.

Each member of the MPC gets one vote as to whether or not rates should change and how much they should go up or down by, or whether they should remain the same.

The group’s overall decision is announced at 12pm on the Thursday.

Why do interest rates charged/ paid by banks and building societies vary so much from the base rate?

There are several factors which banks use to work out what level savings and mortgage rates should be set at, including of course, how much profit they want to make from you. So it doesn’t necessarily follow that your mortgage and savings rates will fall and rise in line with base rate.

Even though the base rate is at 0.5%, the average mortgage standard variable rate is currently 4.75%, for example.

And cheap money schemes such as Funding for Lending have made things much harder if you’re a saver, as they have meant banks and building societies don’t need to attract your money by offering competitive rates.

How quickly will an interest rate rise impact on my finances?

That depends on what kind of mortgage or savings account you have. If you’ve got a tracker mortgage, and your rate is linked to the Bank of England base rate, then your monthly payments will go up the month after any rise.

Even if your deal isn’t directly linked to the base rate, your payments are still likely to increase soon after any base rate rise – your lender will notify you when to expect higher payments.

If you’ve locked into a fixed rate mortgage, then your rate will remain the same for the term of your deal, regardless of what happens to interest rates.

Banks and building societies should, in theory, raise savings rates once the Bank of England increases the base rate. But this won’t always be the case and – even where it is – some of them can be pretty slow.

Others savings providers will pass on any increase in full straightaway, while some may only pass on part of the rise, or keep rates as they are. Again, you should be notified by your savings provider of any change to your savings rate.

If your savings rate is variable and doesn’t increase when the base rate goes up, vote with your feet and move to a better account.

Please note: any rates or deals mentioned in this article were available at the time of writing. Click on a highlighted product and apply direct.

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