An interest rate is simply a number that defines the cost of using someone else’s money. In the majority of cases, ‘someone else’s money’ will be that of a bank, though it could be through a loan company or any other well-known provider. You can either pay interest when you borrow money, or earn interest when you lend money, so understanding what the rate is, what it means and how you can make the most of it for both situations is important.
What’s the Point of Interest Rates?
There are two main reasons for having interest rates. The first is so banks can make money from lending and reward loyal customers for investing their savings with them, as these savings are often what’s used for lending purposes.
Interest rates are also changed to help drive economic growth and keep banks in check. In the USA for example, the Federal Reserve requires banks to maintain ten per cent of total deposits in reserve each night, so they don’t lend out everything they have. Higher interest rates can make lending more expensive and unobtainable for businesses, hampering their growth, while lower rates provide more of a borrowing incentive and can drive growth.
How Do They Work?
Eight times a year the Bank Rate is set by the Bank of England (BoE), though in a lot of cases this involves no movement. This is used in the BoE’s dealings with other financial institutions, which will impact on the other interest rates in the economy.
Commercial banks typically set their rates on a yearly basis. They can also set different interest rates for different products. For example, the rate on a mortgage will differ compared to the rate on a car loan.
Is an Interest Rate Rise Good or Bad?
After a lot of speculation, the Bank of England raised interest rates from 0.5% to 0.75% in August 2018. The BoE sets its key interest rate (the Bank Rate or base rate) as a reference point for other banks and building societies, as to how much they should charge borrowers and pay savers.
Generally, a rise in interest rates is good news for savers, as they should receive higher returns on all the money they currently have in savings accounts. While for borrowers it will mean paying back more, so is often seen as bad news. Therefore, it’s always good to check against the Bank Rate and compare lenders first.
Why Do Loans and Savings Interest Rates Vary?
The interest rates that commercial banks set are based on a variety of factors, not just the Bank Rate. It will depend on what the loan is to be used for, how likely it is that the borrower will be able to repay it and the length of the borrowing period. The greater the risk of a loan not being repaid, the higher the interest, and vice versa, usually. Banks can charge either fixed or variable rates as well.
Interest rates are important for both borrowing and saving, so it’s advisable to compare those available and understand their impact before you start doing either.
