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What are interest rates?
For most of us, interest rates are the amount that we get paid by our bank for saving money, or the amount that we pay our bank to borrow money.
But when people talk about interest rates more broadly, they’re generally talking about the Bank of England base rate. The Bank of England is our central bank, and the base rate is the amount it charges our high street banks for saving their money every night. And the reason the Bank of England base rate is so important is because it’s the basis for all other banks to set their interest rates by.
How are interest rates set?
Interest rates are set by a team of experts known as the Monetary Policy Committee. There are nine of them and they include the Governor of the Bank of England. They meet once a month to decide whether interest rates should go up, go down or stay the same. What influences that decision is what’s happening in the economy more generally, and more importantly what’s happening to inflation.
Inflation is the amount that prices are rising by, and the Bank of England has a target to keep inflation at 2% a year. If it misses that target by more or less than 1%, the Governor of the bank has to write to the Chancellor of the Exchequer to explain why.
Banks and building societies don’t have to set their savings or their borrowing rates at the rate as the Bank of England base rate. The interest rates they set depend on their own costs and how much profit they aim to make.
What happens when interest rates go down?
When interest rates go down it means it’s cheaper for us to borrow, but it also means that savers are rewarded less for keeping money in their bank or building society. That tends to mean that there’s more money in the economy because people borrow more, and savers are less inclined to keep their money in the bank because they’re not getting as good a return, so they’re more likely to spend their money.
So when interest rates are low, that tends to push prices up as people spend more.
The other impact of lower interest rates is that we have a weaker currency – a weaker pound. That’s great for people who make goods and services in the UK and sell them abroad, because it means our goods and services are cheaper for people overseas. However, it’s bad for importers who buy things overseas and bring them into the UK, because it means those things will be more expensive. And that also has the effect of pushing up inflation.
What happens when interest rates go up?
When interest rates rise that means borrowing is more expensive, but savers are getting rewarded more for keeping their money in the bank. That tends to have a negative impact on prices and can push inflation down.
Higher interest rates also have an impact on our currency. It means it’s stronger. That’s great for those of us who are buying things from overseas because it means they’ll be cheaper, but it’s bad for manufacturers and people that are exporting things because it raises the price of goods and services.
What effect can they have on us individually?
Generally speaking, lower interest rates are good news for borrowers and bad news for savers, and vice versa. Many of us have borrowings and savings, so how they affect us individually is rarely straightforward.
Typically, older people tend to have higher savings balances and lower debts (mainly because they have usually paid off a lot of their mortgages).
Younger people tend to have higher debts, from student loans, big mortgages and credit cards; and lower savings balances, because their incomes are not as high.
So older generations tend to cheer rises, and young people have more to celebrate when rates are lower.
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Money Means is a news and information series written by independent financial and consumer journalists and experts. FSCS launched Money Means in 2016 to help give people clear and useful information about personal finance, to increase their understanding and confidence when dealing with money.