What are interest rates and what impact do they have on individuals and the economy?

Interest rates are the cost of borrowing or the return on savings. It is how much you are charged as a percentage of the amount you wish to borrow that you must pay to borrow the money. An interest rate of 5% on a loan of £1,000 equates to interest of £50. If you are saving rather than borrowing, it is how much you will ‘earn’ on the money in your account. So, using the same figures, £50 will be paid in interest. Evidently, as the amount borrowed or saved increases, the impact of the interest rate percentage can be huge.

The Bank of England base rate

In the UK, the Bank of England sets the base interest rate. This rate impacts the interest rates on loans and savings accounts across the market. It is also used to control inflation and work towards stabilising the economy. As of July 2023, the Bank of England base rate is 5%. This follows a sharp and significant rise from 0.25% in January 2022.

What factors influence interest rates?

Inflation

Interest rates rise so that people have less disposable income to spend in shops. With the economic slow-down that will then occur, businesses are dissuaded from raising their prices, lowering inflation.

Economic Conditions

The Bank of England is unable to predict challenging economic events, but it can react to them to minimise impact. Examples include the Covid-19 pandemic and Russia’s war against Ukraine which led to high fuel prices. The Bank of England can adjust the interest rate to try and minimise these events’ impact.

Global Factors

Additional factors including exchange rates, geopolitical events, and trade conditions can impact interest rates across the United Kingdom.

How do interest rates impact individuals and the economy?

When interest rates are higher, the cost of borrowing for both individuals and businesses is higher. One of the most common forms of borrowing for individuals is in mortgages. As the interest rates rise, individuals who are at the end of their mortgage deal are forced to begin a new deal at a higher rate. This means monthly payments are higher and can make home ownership less affordable for many. Conversely, if interest rates are lower, mortgage rates are lower, meaning there is a greater opportunity for first-time buyers to get on the housing ladder.

Interest rates are influenced by, and can also impact currency exchange rates. This can have an impact on tourism in the United Kingdom – tourism makes up a significant portion of the economy – and on the cost of holidays abroad. If exchange rates are unfavourable, it deters individuals from going abroad, and vice versa. From a business perspective, international trade can be impacted by the rise and fall of interest rates. It’s important to note that whilst in recent months this has been a negative impact, in times of a lower base rate this can be very positive.