This article was last updated on 02/02/2023
Interest rates affect the amount you’ll earn on your savings and the amount you’ll need to repay on your debts. When they go up, they can be good for savers but not so great for those with debt. So when rates go up, it’s worth considering paying off debts and moving your money into savings products like pensions.
What is an interest rate?
Interest is money earned on savings or paid on loans. An interest rate is the percentage of money that’s earned or paid. For example, an interest rate of 1% would pay £1 on savings of £100. Or it would charge £1 on a loan of £100.
Interest is usually calculated on an annual basis, but it can be paid on a monthly or quarterly basis. For example, a year’s £1 of interest could be paid in twelve monthly instalments of £0.08.
How are interest rates set?
The Bank of England lends money to high street banks and other financial institutions at a certain interest rate, simply called the Bank rate. Then high street banks set their own interest rates on their products based on the Bank rate.
For example, if the Bank rate is 0.50% then they might lend money to customers at an interest rate of 1%. Or they might pay customers interest of 0.25% on their savings. The difference (called a margin) is one of many ways that banks earn money.
The Bank rate is important, because when it goes up or down it affects what the high street banks charge or pay their customers.
In February 2023, the Bank rate was raised to 4% - up from 3.5% when the rate was last raised in December. UK interest rates are now at their highest for 15 years. The knock-on effects of raising the interest rate make it more expensive to borrow money, but also means that savers earn more on the money in their bank accounts.
What causes interest rates to rise?
So we know that the Bank of England (BoE) sets its Bank rate, which influences the rate of interest set by the high street banks. But what causes the BoE to set its rate higher or lower than before?
A key goal of the Bank of England (BoE), set by the UK Government, is to keep inflation at 2%. In other words, the price of goods and services should only increase by an average of 2% each year. A relatively low rate of inflation prevents living costs from rising too quickly, but it also ensures that companies can continue to earn enough to afford to pay their workers more each year.
To prevent inflation rising above 2% the BoE can raise interest rates, which is good for savers but not spenders. And by discouraging people from spending, the price of goods and services have to drop to remain competitive.
A further knock-on effect impacts high street banks. If the Bank rate goes up, high street banks have to pay more to borrow money from the BoE. And this cost gets passed on to people looking to borrow money, further reducing people’s appetite to borrow.
When will interest rates rise?
The Bank of England’s Monetary Policy Committee (MPC) meets eight times a year to decide whether to change the Bank rate. Usually, no change is made. But when it does, it’s usually because the economy is going through a period of substantial change.
Interest rates typically rise when inflation rises (or is predicted to rise) above the 2% inflation target. However, the BoE doesn’t react to what it regards as short term economic ‘shocks’, preferring to react with a medium term view. This is partly because there’s a lag between changing the Bank rate and its effect on the economy, and partly because changing the rate so often could cause further financial instability for millions of people.
By October 2021, inflation sat at 3.20%. According to the BoE, “Inflation has been affected by global developments, particularly the economic recovery from the worst of the pandemic, and supply constraints in certain sectors.”
While that was above the 2% target, the BoE decided not to increase interest rates. They expected inflation to fall on its own once the issues that were impacting inflation were resolved.
In December 2021, the Bank of England raised its interest rate to account for faster-than expected inflation and the emergence - and potential disruption - of the Omicron Covid variant.
The rate was raised again in February 2022 and then again in March 2022, in further attempts to slow down the rapid rise in the cost of living. The first rise followed an earlier announcement by energy regulator Ofgem that the energy price cap (which limits how much energy companies charge) was to increase by 54%, inflating living costs even further. The second rise followed a sharp increase in the cost of raw materials and energy, following Russia’s invasion of Ukraine.
What to do when interest rates rise
If interest rates were to rise in the future, savers and borrowers would be impacted differently.
When interest rates go up, banks may increase the rate on some of their savings products. So if you keep money in a savings account, you may want to use a comparison site to see whether you’ve got a good deal. If not, you may want to switch to a better deal. It’s also a good time to think about putting any spare cash into a savings account to earn interest.
If you have existing debt like a student loan or a mortgage, you may see your payments increase. Those with a fixed rate deal will be protected against any short-term rate increases. But those with variable rate deals could see their payments rise immediately.
In this situation, you may want to consider paying off your debts as quickly as you can afford to do so. This will prevent your debt growing further and become more costly to repay over time.
When interest rates go up, the market ‘reshuffles’ as older deals are replaced by new ones. So it’s worth shopping around to see if there are more suitable deals out there for you.
How do interest rates affect pensions?
A pension will invest your cash into the stock market and other assets, depending on the pension plan you choose. This could be preferable to holding cash in a bank or savings account, since interest rates are often unable to compete with stock market growth - despite guaranteeing your money won’t lose value, unlike stock market investments.
The stock market isn’t directly affected by interest rates, but it can be affected indirectly. That’s because a company’s value is partly based on its current performance. So if high interest rates encourage people to save rather than spend, a company may sell less products. And that could make it less attractive to investors, lowering its share price.
Another way a rise in interest rates could affect a company’s stock market valuation is if the company holds a lot of debt, since higher interest rates will increase the amount the company has to pay to service the debt. And this would affect a pension’s returns.
Risk warning: As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.