On Thursday, May 5th the Bank of England announced a rate hike of 25 basis points from 0.75 to 1 per cent, the highest level seen in 13 years. What a lot of you may be asking: what are interest rates and how do they affect me?
What are interest rates?
“An interest rate tells you how high the cost of borrowing is, or how high the rewards are for saving.” -Bank of England
An interest rate is an amount paid by a borrower to a lender, on a loan that has been taken out. For example, let us say you want to buy a car. You need £10,000 to buy the car, but you only have £5000. You decide to go to a bank and get a loan of £5000 so you can afford the car. What does the bank get from lending to you? The answer is the interest rate.
On the loan you take out you will have to pay a certain amount of “interest”. If the bank's interest rate is 5%, every year until the loan is paid back you will have to pay £250. The same works in the reverse scenario. If you decide you want to keep your money in a savings account within the bank, you are essentially lending your money to the bank. Therefore, if you decide to keep £10,000 in a savings account with a simple interest rate of 2%, each year you would earn an additional £200. Therefore, high-interest rates encourage people to save and discourage people to take out loans and low-interest rates encourage people to take out loans and discourage people to save.
How are Interest Rates Used?
Central banks like the Federal Reserve and the Bank of England use interest rates to steer the economy. Nick Timiroas of the Wall Street Journal says you can think of an economy as a car and the central bank as the driver. If the economy is growing too slow, the central banks press the gas to gain more speed and meet their targets (they will cut interest rates). If the economy is going too fast, the central banks will press the brakes to slow us down (they will raise interest rates).
Imagine: economic growth is slowing, inflation is below the UK target of 2% and unemployment is high. To stimulate the economy the Bank of England decides to cut interest rates to 0.5%. A low-interest rate means the cost of borrowing falls, firms are encouraged to take out loans to expand their businesses. Businesses decide to raise wages to attract more employees. These employees, now with higher wages, decide to spend more.
This then leads to a cycle of higher growth as consumption rises. Lower interest rates also provide a disincentive to save as savings will provide lower gains. Consumers then decide to spend their savings or invest them, this injects further cash into the economic system. Economic growth is now at a normal rate, inflation is at the target of 2% and unemployment is low. Essentially, interest rates are a tool used by central banks to stimulate or depress the economy.
Current Interest Rates
Currently, global inflation is surging. COVID-19, rising oil prices, the war in Ukraine and Russia: a large multitude of factors are causing high inflation levels. The current inflation rate in the UK is 7%. The highest seen since March 1992 when it stood at 7.1%.
“Inflation in the UK is likely to keep rising to around 10% this year" -Bank of England
With rising inflation, the cost-of-living crisis, and geopolitical tensions rising, the average consumer is being hit worst as fuel prices rise from 128.43p per litre on May 18th 2021 to 165.62p per litre on May 13th 2022. To combat rising inflation the Bank of England has raised interest rates to 1%, the highest since the global financial crash. Australia has raised interest rates for the first time in 11 years and India has hiked rates for the first time in 2 years. The Federal Reserve’s interest rate was raised by 0.5 percentage points to a target rate range of between 0.75% and 1%.
How will this Affect You?
A rise in interest rates means the cost of borrowing may rise for you. It will affect credit card loans, mortgage rates and car loans. If you have a standard variable rate (SVR) mortgage the amount you have to pay will likely rise along with the Bank rate. However, only around 26% of homeowners are on SVRs. If you are not sure what mortgage you have you can contact your mortgage provider for more information. If you have a savings account with a bank that pays interest you may see the amount paid to you per year increase.
Bank of England interest rates since 2012:
The Bank of England is anticipating inflation to rise to 10% by Autumn and the market is predicting more interest rate hikes. The Office for Budgetary Responsibility predicts that if the UK experiences sustained higher inflation then we could see rates hit 3.5%.
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