MoneyMagpie

Mar 04

What are interest rates and how do they work?

What are interest rates, you might ask, when you’re saving money, or even more when you’re borrowing money? Bank interest rates affect us any time we have dealings with money so it’s important to know what they are and how to get the best deal. 

  • What are interest rates?
  • What is the Bank of England base rate?
  • What do bank interest rates mean for you?

What are interest rates?

Interest rates are the ‘rate’ (the price, if you like) that someone pays for borrowing money.

You might not think of it in that way if you are saving money with a bank and they offer to pay you interest, but in fact they are borrowing money from you and they are paying you interest for borrowing it.

It’s a bit like renting really.interest rates

When you ‘borrow’ money you actually ‘rent’ it because you are charged ‘interest’ for every day/month/year that you have that money. As with renting a flat, the longer you rent it for, the more you end up paying.

Also, as with rent on a flat, the amount you pay per month differs greatly from one place to another. The more expensive it is per week, the more you will pay overall.

So, if you’re borrowing money, you will want to go for the lowest ‘rent’ you could possibly pay (in other words, the lowest interest rate).

If you’re saving money and you want the bank to pay you rent for it each month, you want to go for the highest interest rate you can get.

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What is the Bank of England base rate?

To get the hang of interest rates it is important to understand inflation. Inflation is the change in buying power of a given amount of money – it’s the rise in the cost of living. Over time, buying power of your money tends to fall (in other words, inflation, the cost of living, rises) because there’s an increase in the number of people in the country and they all want a piece of our limited set of resources (everything from oil to land to food).

So, £100 buys much less today than it did 100 years ago. Inflation happens when the amount of money spent grows more quickly than the country’s production.bankofengland

In the UK, inflation is measured by the Consumer Price Index (CPI), which is the government’s measure of how much things cost. It’s a bit like a big shopping basket that contains all the things the average family uses each month. It has a bit of transport, a bit of food, a bit of furniture and some other bits and bobs like household costs. If the total price of the things in the basket rises, inflation has risen.

It’s not a good idea for inflation to rise unchecked, because then everyday things would cost far too much for the general public. So the government, or more specifically the Chancellor of the Exchequer, sets an inflation rate target.

The UK’s central bank, the Bank of England, has the job of making sure the country meets (and doesn’t exceed) its inflation target.
To keep inflation in check, the Bank of England sets an official interest rate, the Base Rate. This is the rate at which it lends money to banks and other lenders who then lend it on to us. Banks use this ‘official rate’ to decide how much interest to give you in return for the use of your savings.

So…

  • If inflation is rising too quickly, the Bank of England will raise interest rates. This means it will cost more for you to borrow money (for things like mortgages) but you will get a little bit more for your savings.
  • The government raises interest rates to encourage the public to save more and spend less.
  • A few years ago however it has lowered rates to boost spending. Rates were at 5.0% as recently as October 2008. But heavy cuts have seen them hit an all time low of 0.5%. Rates are now so low that cutting them any further would have little effect on the economy. The only way is up for rates, but as the economy is so fragile right now that’s unlikely to happen for a while.
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What do bank interest rates mean for you?

Lower interest rates mean:

  • It costs less to borrow money from banks or other lenders. Lower rates are particularly good for those on tracker mortgages. But not all rate cuts have been passed on in full by the banks to their customers who are on Standard Variable Rates.
  • Saving becomes less attractive. Saving your money in the bank earns you less the lower rates go. Extremely low interest rates are bad for those dependent on income from their savings. What’s good news for borrowers is bad news for thrifty savers.
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