Things that affect interest rates, and why they change

Interest rates get mentioned a lot, but they aren’t always fully explained. Yet they’re relevant to anyone who is borrowing or saving money. 

Simply put, 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 usually have an interest rate, expressed as an annual percentage.     

For example, putting £1,000 into a savings account with a 1% interest rate would earn you £10 over the course of a year.

Why interest rates matter

High or low, interest rates are important because they influence the borrowing costs and spending decisions of consumers and businesses. While low interest rates can encourage people and businesses to borrow money for things like mortgages, big purchases, or investments, higher interest rates often do the opposite, and can restrain consumers and businesses from borrowing.   

Here are the few ways interest rates can affect our finances:

The way people spend money

In theory, if interest rates are low and people are paying less in interest, they have more money to spend, which can lead to a wave of increased spending throughout the economy.

And it’s the same for businesses. A lower cost of borrowing might encourage them to make bigger investments in equipment or services, which in turn boosts output and productivity and helps to lift the economy.

How much it costs to borrow money

High interest rates mean that businesses and people in debt will be paying more interest to lenders. This can result in consumers having less disposable income and buying fewer things. 

How much people save

When interest rates on savings accounts are higher, people also tend to be more likely to save, due to the higher rewards they’ll receive for keeping money in the bank. 

What makes savings interest rates go up or down?

Changes to UK banks’ saving interest rates do happen fairly regularly. This is because interest rates can be variable, and so can fluctuate depending on what’s happening in the economy.  

Some key factors include:

• Inflation
  Interest and inflation usually correspond  to one another. Generally, the lower the interest rate, the more buying power the consumer can have. This can increase spending, which causes prices to go up – or inflate. If demand starts to outpace supply, interest rates may go up, slowing the amount of money flowing into the economy.
  
  Read more about inflation and interest rates
   
• Base rate
  In the UK, interest rates are influenced by the Bank of England base rate. If the base rate goes up or goes down, it can affect the savings rates that banks offer to customers – and ultimately how much interest you can earn on your savings.  
   
• Other banks or building societies changing their interest rates
  When some banks or building societies change their interest rates, other banks may find they need to follow suit. This is so they can manage the growth of their business in a sustainable way.

What about negative interest rates?

The Bank of England’s base interest rate is normally lowered when it wants people to spend more and save less to boost the economy – for instance, in the middle of an economic crisis.   

Currently, UK interest rates are still very low following the Bank of England’s decision in March 2020 to cut the base rate to 0.10% in a bid to stimulate the economy as the effects of the coronavirus pandemic hit.  

Negative interest rates could happen if the Bank of England wanted to stimulate the economy and charge banks to store their cash instead of earning interest on it.  If banks passed this charge onto customers, having to pay to hold cash at your bank is likely to discourage saving and in theory, encourage spending.

Looking to the future: will interest rates go up?

Despite UK interest rates being at some of their lowest ever levels, it would be highly unlikely for them to stay this way forever. And the good news is, if interest rates do rise, you could start to earn more on the money in your savings accounts. 

But it’s important to remember that this will count towards your Personal Savings Allowance, and higher interest rates mean you may use more of your allowance more quickly.  This means that more (or all) of your savings held outside an ISA could end up being subject to tax. 

Putting money in an ISA instead could help you future-proof your savings, as the money you hold in an ISA keeps your savings sheltered from UK tax for the future. 

Read more about cash ISAs