Our introductory article on interest rates changes explains what interest rates are, how they are set and why they are important. In this article we look at interest rates in a bit more depth and how a rate change might affect different types of borrowers and savers.
Short-term rates and long-term rates
As explained in our introductory article, the Bank of England Base Rate is a very short-term interest rate. Commercial banks borrow at this rate from the Bank of England between the end of one business day and the start of the next one in order to balance their books.
However, it is possible to borrow and lend over much longer periods.
People who have taken out fixed-rate mortgages will have experienced longer-term interest rates, usually fixed for two, three, five or even ten years. Regardless of what happens to short-term interest rates, borrowers pay the same fixed rate until the end of the agreed period.
It’s also possible to deposit money (effectively lending money to borrowers) using fixed-term deposits typically over periods of 6 months to five years. Again, the depositor receives a fixed rate of interest for the given period.
The government borrows money – and investors like you and I lend the government money – over anything from 6 months to 55 years, but more typically over 5, 10 and 30 years. When the government borrows, it issues promises - called ‘bonds’ or ‘gilts’ - to pay back the lender/investor at the end of the fixed period and, in the meantime, pays the lender/investor a fixed rate of interest, known as a ‘coupon’.
Once issued, gilts are traded between investors and the market prices paid for gilts reflect the expectation for interest rates over the remaining period of the gilt. For example, if investors are paying more than the £100 face value of a gilt, that means that expected future interest rates over the remaining period of that gilt are below the interest rate or coupon of that particular gilt.
Long-term interest rates are usually higher than short-term interest rates. Lending money to someone over 30 years is more uncertain and risky than lending to them for a few days, so the interest rate charged on longer-term loans usually reflects that risk.
Now that we understand the difference between short-term and long-term interest rates, let’s have a look at how interest rate changes might affect you.
A change in the Bank of England Base Rate is likely to have an immediate impact on variable rate mortgages. The interest payable on variable rate mortgages fluctuates according to short-term interest rates. So, when short-term rates fall or rise, the variable mortgage rate will likely fall or rise too. A change in short-term interest rates will also have an immediate impact on discounted variable rate loans.
Fixed rate mortgages are not immediately affected by short-term interest rate fluctuations as the rate is locked until the end of the fixed period.
Whether a fixed or variable rate is best for you depends on your circumstances, for example, your ability to absorb unexpected interest rate changes. Speak to a financial adviser who will help you choose the best mortgage to suit your needs.
Credit cards and personal loans
The interest paid on credit card debts is likely to change immediately in response to a change of Bank of England base rate. The interest rate on personal loans over short periods e.g. 12 months, would also be likely to change quickly. However, like fixed rate mortgages, the rate available on longer duration personal loans may not change immediately.
The credit crisis, and the loose economic policy that has followed, have not been good for cash investors. Interest rates have hovered near all-time lows for over 6 years.
So, a further interest rate cut would not be welcomed by cash depositors who would, once again, see the interest rate on their savings cut again.
However, a cut in the Bank of England Base Rate is not a guarantee that the rate of interest on your deposit will fall immediately. The bank or building society that holds your deposit may not pass on the full rate cut. This could be because they want to offer competitive saving rates.
If you have locked into a fixed-term deposit, a rise in short-term interest change will not affect the rate you receive. However, it may be a signal that interest rates are falling. This may mean you won’t get the same rate when the time comes to replace or renew your current fixed-term deposit with another fixed-term deposit or a variable rate deposit such as an instant access account.
Low interest rates emphasises the importance of making the most of the available tax advantages. Individual Saving Accounts (ISAs) and pensions both carry tax benefits which can boost your savings when compared to other savings products. Click here for more information about ISAs and pensions.
Annuities pay a guaranteed income for life. They effectively return the investor’s capital plus a long-term interest rate net of costs and charges to the investor over their remaining lifetime.
Most people buy annuities between the ages of 60 and 65 when life expectancy is typically another 25 to 30 years. For this reason, annuities lock into investments that provide long-term returns.
Like fixed-rate mortgages and fixed-term deposits, a fall in short-term interest rates may not have an immediate impact on long-term rates of return. So it is by no means certain that annuity rates will fall if short-term interest rates fall.
However, a further cut in short-term interest rates may be seen as a signal that rates may continue to remain at low levels and this may begin to push down long-term interest rates.
Increasing life expectancies also influence annuity rates. Life expectancies have historically increased at a steady and relatively predictable pace. If this improvement continues, that could have the effect of accelerating any falls in annuity rates resulting from a fall in long-term interest rates. At times like these, shopping around for the best annuity deal for you has never been more important.
The most common form of releasing equity from your home is to take out a lifetime mortgage. Like annuities, lifetime mortgages are based on life expectancy and therefore lock into long-term interest rates. Also like annuities, a fall in short-term interest rates such as the Bank of England Base Rate, may not necessarily lead to an immediate fall in equity release lifetime mortgage rates.
However, a fall in short-term interest rates may signal the start of a trend and begin to push down long-term interest rates such as the rate on lifetime mortgages too.
Stock markets and share prices are not directly impacted by a change in short-term interest rates, although they could be affected indirectly.
If interest rates fall, borrowers may have more free money to spend on discretionary items such as eating out or going on holiday. Businesses that rely on customers spending discretionary income may therefore be affected indirectly if their typical customer is a borrower rather than a saver.
Like people with mortgages and credit cards, some businesses are also borrowers, so a cut in interest rates may affect the cost of their borrowing, and their profits, too.
Aside from interest rates, many other factors affect companies’ share prices. For example, new products or services offered by a business that might allow it to sell more or charge more, whether its customers are mostly in the UK or overseas, currency exchange rates if the business imports goods or raw materials and general economic conditions.
Given the higher levels of uncertainty surrounding the UK economy at this time, we can expect all share prices to remain volatile for some time. As always, it is therefore sensible to see shares as a long-term investment.