What’s the difference between interest and inflation?

And how do they both affect your savings?

16 February 2021

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Interest and inflation impact our day to day lives, from how much money we can borrow for a loan to the cost of our weekly food shop. Read on to learn more about how the two are linked – and why they can both affect your savings.

In short

Interest is a percentage charged on the total amount you borrow, or earned on the total amount you save.
Inflation is the rate at which the price for goods and services increases.
The Bank of England occasionally raises or lowers the base rate to help influence the UK economy.

How do we measure inflation?

Inflation is the rise in cost of goods (like appliances or food) and services (such as beauty treatments or air fare) over a period of time.

According to the Bank of England, it’s usually measured by comparing the price of something today to the price of that same thing a year ago. For example, if a loaf of bread cost £1 last year and costs £1.03 today, you could say the price of a loaf of bread has risen by 3%.

In the UK, inflation is measured by looking at the prices of a list of good and services. The Office for National Statistics (ONS) then uses this list to work out the Consumer Price Index (CPI). The Bank of England monitors the CPI to understand inflation over time.

Why the rate of inflation is important

As the Bank of England explains on its website, it’s important for inflation to be stable and not too high. If it fluctuates too often, or goes up too much, it makes it difficult for businesses to set prices for things – like the cost of a new car for example. It also makes it hard for people to plan how to spend their money.

When inflation is too low – or even negative – people may stop or reduce their spending because they expect prices to continue dipping. And if people stop spending, companies could go out of business and people could lose their jobs.

Where does interest come in?

Interest is the percentage charged on the total amount you borrow or earned on the total amount you save. Accounts that offer a service to save or borrow money will probably have an interest rate.

On your savings accounts, most banks will pay interest to you for saving your money with them. If you’ve got a loan from the bank, you (the borrower) will most likely be charged interest on the money you borrow.

If the interest rate increases on your savings account, you will earn more. But if it increases on money you’ve borrowed, you will pay more.

How changes to the Bank of England base rate affect interest and inflation

The Bank of England will occasionally raise or lower the base rate to help influence the UK economy.

The base rate will typically be lowered to try to stimulate the economy. For example, if consumer spending is low and fewer people are borrowing from banks, the base rate may be lowered.

This aims to encourage spending and more demand for credit. Because banks set their pricing based on a number of factors – including the base rate – it can become less expensive for borrowers to repay if the base rate falls, but banks may also reduce the interest rates they offer savers.

The Bank of England can increase the base rate with the opposite aim: if this happens, the cost of borrowing may go up, and in turn the interest you earn on your savings could increase too.

In summary

The inflation rate and interest rates are intrinsically linked. When the inflation rate is high, interest rates tend to rise too – so although it costs you more to borrow and spend, you could also earn more on the money you save.

When the inflation rate is low, interest rates usually go down. This often helps stimulate spending, as the cost of goods and services is lower – and credit costs you less. But it also means that savings rates go down too.

Examples taken from Bank of England website. The content in this article is for information only and is not advice. All content in this article was accurate on the date of publication shown above.

The content in this article is for information only and is not advice. All content in this article was accurate on the date of publication shown above.