How do interest rates affect me?

What are interest rates?

An interest rate shows how much you could earn from your savings account, or how much it will cost you to borrow money. 

If you’re looking to deposit money in a savings account, the interest rate offered represents the payment the company you’re depositing your money with will pay you for choosing to save with them. Companies offer interest on deposits because they want to attract money to lend out or invest. 

On the other hand, if you’re looking to borrow money from a bank, the interest rate is a charge you will pay them for loaning you the money.

The interest rate on borrowing is referred to as the APR, which stands for the annual percentage rate. This represents the total cost of your loan for a year, and it includes any fees and interest you’ll have to pay. 

Interest rates play a vital role in the UK's economy, and influence the behaviours of savers and borrowers. Low rates encourage borrowing which in turn boosts consumer spending, whereas high interest rates encourage saving and can reduce consumer spending. 

Why are interest rates going up?

The main reason interest rates in the UK are currently high and getting higher is to control inflation.

If the prices of things keep going up too fast, it can make it harder for people to buy what they need. This is exactly what we’ve seen in the UK over the last year, with food costs in particular growing at an alarming rate.

So, in an attempt to reduce inflation, the Bank of England has decided to raise the base rate. 

The base rate is the UK’s official borrowing rate for banks and building societies, and when it goes up it costs them more to borrow. Therefore, they usually increase the interest rates they charge for their loans and mortgages to compensate for this increased cost. 

The aim of raising the base rate is to increase the cost of borrowing and make saving more attractive. It is hoped that this will lower consumer spending, and reduce the demand for certain goods and services, which could slow down inflation. 

How are interest rates set on savings?

There are a few important factors that banks and building societies consider when setting interest rates for savings accounts.

As mentioned above, the Bank of England base rate plays a major role in the interest rates banks choose to offer for their savings accounts. 

When the base rate goes up, banks and other financial institutions tend to increase the rates they offer to savers. This is because they need money to operate their lending and investment services. When rates go up, it costs banks more to borrow money through the financial markets, so they tend to increase saving rates to attract more deposits instead. 

Another important factor is competition. Banks and building societies compete with each other for customers. How many banks want deposits, and how many customers are looking for deposits, will influence how competitive the savings market is. When more banks want deposits and less customers are looking to make them, rates will be pushed higher.

Savings rates may also vary from bank to bank, depending how much profit they are making from lending the money. They need to ensure they earn enough interest from this to cover the cost of the interest they pay on savings. If their profits from lending increase, it may give them more scope to raise savings rates.

Savings rate will also vary greatly depending on the type of account you hold. As a rule, fixed-rate accounts which require you to tie your money up for a set amount of time pay the highest rates. This is because the banks take into account the certainty of knowing how long they will hold your money for and the interest they’ll have to pay.

Because of this, it’s usually the case that the longer the fixed term period, the better the rate offered. However, this may not be the case if the Bank of England base rate is expected to fall and the bank expects to pay less interest on savings in future.

Alternatively, instant access savings accounts that allow you to withdraw and deposit money whenever you want, tend to offer lower interest rates in comparison. 

How are interest rates set on borrowing?

Interest rates for borrowing products like personal loans and mortgages are influenced by many of the same factors as savings accounts. 

The base rate has the most obvious direct impact on borrowing rates. When it is high, it means it is more expensive for banks to borrow, so in turn they have to increase their rates to cover their costs. The opposite is true when the base rate is low.

The main reason we are currently seeing such high interest rates for mortgages is because the Bank of England base rate has gone up from 0.10% in December 2021, to 5.25% at the time of writing. This is the highest rate we’ve seen since before the financial crisis in 2008. 

Here are a few other factors that can influence how interest rates are set on borrowing:

• Creditworthiness and risk: When you look to borrow money, lenders assess your creditworthiness to work out how likely you are to repay the loan. This is influenced by things like your credit history, income, employment, and existing debt. If you have a good credit history you may be offered lower interest rates. Alternatively, if you have a poor credit history lenders may charge higher interest rates because of the increased risk.

• Market competition: Like with savings accounts, banks and lenders compete with each other to attract borrowers. If one bank offers lower interest rates on loans, it may mean more borrowers choose them. To stay competitive, other lenders may lower their interest rates as well. 

• Loan type and term: Different types of loans and their terms can also influence interest rates. For example, mortgages, personal loans, and credit cards will have different rates based on things like the length of the loan, the amount of any deposit put down, and the repayment terms.

How will interest rates affect my savings?

Increasing interest rates is good news if you have savings. Although it has been argued that banks have been slow to pass on savings rates to customers, the increase in the base rate has led to higher rates for savers.

Higher rates essentially mean you’ll be earning more money from your savings. As an example, if you have £10,000 saved in an account paying 5% interest, that means that after a year you’ll have earned £500 interest which is usually added to the balance of your account. 

The higher the rate, the more interest you will earn and the faster your savings will grow. 

How will interest rates affect my mortgage?

The increase in mortgage rates has been startling over the past few months. Lenders have been hiking their rates in response to the increases in the Bank of England base rate, which has meant the monthly repayments for many UK homeowners have skyrocketed.

The effect these increases have on you will depend on your mortgage product. Those on variable rates, or deals that track the lender's standard variable rate (SVR), will have seen their repayments go up almost immediately in line with the base rate increases. 

Those in fixed-rate deals, where the interest rate of the mortgage doesn’t change during the term of the product, won’t be affected until their deal ends.

However, those with deals ending are finding that even the best new products will increase their mortgage repayments by £100s. If you are on a fixed term deal it’s a good idea to start planning for when it’s over. For example, you could work out how much your new repayments will be and update your budget to see if you’ll have to make any spending or income changes to cover this.

Which providers give the best interest rates on savings?

The best interest rates available change all the time, so the only way to find the best rates is to shop around when you’re ready to open a new savings account. 

Use a comparison site that allows you to compare the latest rates, but don’t always just choose the account that pays the most interest. Make sure you consider things like:

• What you’re saving for - is it for a specific goal where a certain type of account could be better e.g. pension for retirement savings?

• The access available on the account - can you withdraw money at any time, or will your savings be tied up?

• The deposit limits - is there a maximum or minimum amount you are allowed to deposit into the account?

• Paying tax on your interest - Can you save in an ISA which means you can save tax-free on up to £20,000?

All these factors need to be considered so you choose the type of savings account that best matches your needs and circumstances. 

How can I protect myself from interest rate changes?

It can be tricky to fully protect yourself from interest changes because it’s difficult to know whether they will go up or down, or what they will look like in the future.

However, there are some steps you could consider:

• Fixed-rate savings accounts: While interest rates are high, you might want to consider putting some of your savings into fixed-rate savings accounts. These accounts offer a set interest rate that remains the same for a specific period, even if general interest rates go down. This way, you can guarantee a certain rate and protect your savings from changes during that fixed term.

• Diversification: Instead of keeping all your money in traditional savings accounts, you may want to explore other options like stocks, bonds or property. Different types of investments may be affected differently by interest rate changes. However, make sure any assets you choose match your risk profile - with some investments you could be at risk of losing some or all of your initial deposit (known as capital).

• Consider long-term loans: Choosing to take out a long-term loan or mortgage is a tricky decision right now as rates are so high. However, fixing your repayments for as long as possible, at a rate you can afford, is an option to give you certainty for future costs.

• Build an emergency fund: Emergency savings can act as a safety net during tough times like rising interest rates, for example, to put towards increased mortgage repayments 

• Stay up to date: Try to keep track of the latest financial news so you’re aware of any potential changes to interest rates. Understanding when rates might change can help you anticipate potential changes and adjust your financial plans accordingly.

• Financial advice: If you’re not sure about how best to manage your borrowing or savings, consider getting financial advice. An independent financial advisor can provide personalised advice based on your financial goals and attitude to risk.

Remember, interest rate changes are a normal part of the economy that you need to be able to adapt to. By diversifying your savings and investments and being well-informed, you can better protect yourself from the impacts of changing interest rates and maintain financial stability.