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 rise 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.
An increase 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 rise, the variable mortgage rate rises too. A rise 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.
However, if short-term interest rates are trending upwards this could be a signal that long-term interest rates may also rise over time. That could mean that fixed-rate mortgages rates also start to rise and the rate available may be higher than current fixed rates when the times comes to renew or replace your current fixed-rate mortgage.
The best time to lock into a fixed rate mortgage is when interest rates over your preferred fixed period are at their lowest and before the market begins to anticipate and price in an interest rate rise.
Whether a fixed or variable rate is best for you depends on your circumstances, for example, your ability to absorb unexpected interest rate rises. 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 rise immediately. The interest rate on personal loans over short periods e.g. 12 months, would also be likely to rise quickly. However, like fixed rate mortgages, the rate available on longer duration personal loans may not rise immediately unless there is an expectation of further rate rises.
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, an interest rate rise would be welcomed by cash depositors who would, at long last, see the interest rate on their savings begin to increase.
However, an increase in the Bank of England Base Rate is not a guarantee that the rate of interest on your deposit will rise immediately. The bank or building society that holds your deposit may not pass on the full rate rise. This could be because they want to offer competitive mortgage rates or increase the margin they make between depositors and borrowers.
If you have locked into a fixed-term deposit, a rise in short-term interest rates will not affect the rate you receive. However, it may be a signal that interest rates are rising. This may allow you to get a better 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.
Most buy-to-lets are financed with mortgage borrowing as mortgage interest can be offset against rental income and therefore reduce taxable profits.
Buy-to-let investors also have the same trade-offs between variable rate loans and fixed rate loans faced by people who mortgage their own home.
However, buy-to-let investors face another issue when interest rates rise; higher interest means higher costs, which means less profit or even the prospect of making a loss. It might be possible to put up rents to compensate for higher mortgage interest, but only if other landlords are raising their rents too.
The government has also signalled that the rate of tax relief on mortgage interest payments for buy-to-let investors is to fall to 20% by 2020/21. This is likely to put more pressure on the profits that buy-to-let investors make, and therefore a desire on their part to raise rents to compensate.
Annuities pay a guaranteed income for life. They effectively return the investors’ 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 rise 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 rise if short-term interest rates rise.
However, a rise in short-term interest rates may be seen as a signal that rates may continue to rise and this may begin to push up 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 cancelling out some or all of any increase in annuity rates resulting from an increase in long-term interest rates.
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 rise in short-term interest rates such as the Bank of England Base Rate, may not necessarily lead to an immediate increase in equity release lifetime mortgage rates.
However, a rise in short-term interest rates may signal the start of a trend and begin to push up 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 rise, borrowers will have less 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.
As we have seen over recent years, even businesses such as supermarkets where people spend on non-discretionary items, may have to cut their prices as customers with less money to spend seek out bargains elsewhere.
Like people with mortgages and credit cards, some businesses are also borrowers, so an increase 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.
Corporate and government bonds
Normally, a rise in interest rates will lead to a fall in the value of corporate and government bonds. Bonds bought with a low effective yield will look less attractive if interest rates go up and, therefore, the price will fall to reflect the market rate of interest available for that duration of loan.
However, the impact will depend on the remaining duration of the bond, and a bond with many years still to run may see little change resulting from a rise in short-term interest rates.
Bond prices also depend on other factors such as the relative attractiveness of the borrower. A company, which has very low profits or a weak balance sheet, may have to pay a higher rate of interest to borrow money than a company that is financially strong.
Economic conditions, particularly expectations of future inflation, also have a large bearing on the price of bonds as investors are interested in the real (after inflation) rate of return rather than the nominal rate of interest or yield.