Interest rates - What are they, how are they set and why they matter

There has been significant talk about interest rates in the media. So, what are interest rates, how are they set and why do they matter?

What are interest rates?

Interest rates, along with tax rates and foreign exchange rates, are one of the key levers the authorities have to manage the UK economy. The health of the economy affects us all, so the manipulation of these rates is important.

When the media refers to interest rate changes it is normally referring to the Bank of England base rate. This is the interest rate the Bank of England (i.e. the UK’s central bank) charges commercial banks for money borrowed overnight which is used to balance their books. As consumers we do not pay this rate, but it has a knock-on effect on the borrowing and lending rates set by high-street banks and building societies.

How are interest rates set?

Since 1997 base rates have been set independently by the Bank of England, free from direct political influence. The government sets the Bank of England a price inflation target, and it is the Bank’s responsibility to manage interest rates to meet this target. The current target is to achieve a long-term inflation rate (consumer price inflation or CPI) of 2%.

The Bank of England’s Monetary Policy Committee (MPC) meets each month to agree the interest rate. It is a nine-person committee, chaired by the Governor of the Bank of England. Five of the MPC members are senior Bank of England employees and the other four are external experts, appointed by the Chancellor of the Exchequer.

At each MPC meeting, the members consider various wide-ranging economic factors and vote on the proposed interest rate following a recommendation from the Governor. A straight majority vote determines the MPC’s decision and this is published the following day at 12 noon. You can see these publications here 

Why do they matter?

The activities of the MPC may appear technical and beyond many of our daily lives, but their decisions affect all of us. There is increasing speculation that the Bank of England may choose to slowly increase interest rates in the coming months, so let’s consider what effect this could have on us.

A higher base rate is likely to encourage high-street banks and building societies to increase the interest rates they offer to us. This would increase the income we receive on our savings but would also increase the interest we pay on any debts we hold. For younger people, particularly those who have not yet reached retirement, the most significant impact would be an increase to our mortgage repayments. The main beneficiaries of higher interest rates paid on cash savings would be pensioners as this age group hold the most money per head in cash deposits. 

Higher interest rates can also depress the prices of assets such as property and shares. Property prices could fall as higher mortgage costs depress demand. Share prices may fall for a variety of reasons, for example as a result of a company having to spend more money financing its debts or because its main customers are younger borrowers who now have less money to spend. But equally, some share prices might rise.

Higher interest rates could also impact foreign exchange rates. A higher interest rate could make Sterling a more attractive currency to investors so increase the value of Sterling relative to other currencies. This would reduce the price of imports and increase the price of exports. As a trading nation, a change in the exchange rate is significant for the UK.

What does this mean for you?

UK interest rates have been held at a low of 0.5% since March 2009. The last time interest rates went up was in July 2007, so we have not experienced moving interest rates over recent times. For example, since 2009, about 1.8m first-time buyer loans have been taken out, according to the Council of Mortgage Lenders .

As outlined above, a change in interest rates could affect various elements of our financial lives. It is impossible, however, to quantify the size of these impacts in advance. Regardless, a good first step is to be prepared – to understand the potential impact and consider how it could affect your financial position.

Aviva’s Budget Calculator could be a good place to start. By considering the various elements that make up your income and your outgoings, and understanding the directional impact an increase in interest rates could have on these, you will be a positive step closer to being prepared for any changes.

You can see the Aviva Budget calculator here:

You can also mark your diary for upcoming Bank of England decisions. These are published on their website.  

Finally, try not to panic. No major shift in interest rates is anticipated. The Governor of the Bank of England assured borrowers that any rate rise “would proceed slowly”.

For information on how interest rates can affect savers and borrwers finances, read 'Interest rate changes - what impact do they have on people's finances?'

AR01582 12/2015

 

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