A complete guide to interest rates - All your FAQs answered

Interest rates explained

Understanding how interest rates work can be a tricky topic to wrap your head around as there are numerous types of interest rates that you need to be aware of when comparing deals online.

In this guide, we’ll take you through everything you need to know about interest rates in the UK, the relationship between inflation and interest rates, as well as some of the predictions for the future.

What is an interest rate?

In terms of borrowing money, an interest rate is a percentage that is charged on the amount of money that you borrow. Usually, it is expressed as an annual percentage of the loan.

With regards to interest rates and savings, it is the percentage amount that your bank or building society “rewards” you with for saving your money with them.

You may also be familiar with mortgage interest rates and credit card interest rates. You will be charged on borrowing money for both of these things, and it’s important to remember that interest rates aren’t linear and can increase or decrease alongside inflation and deflation. 

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How do interest rates work?

In the UK, the Bank of England (BoE) is in charge of setting the interest rates for the country. Currently, the base rate is at 0.1%. While this rate won’t be the same for every single financial institution, it does set a precedent for banks and building societies who can then decide what interest rates they want to charge themselves.

For example, if the base rate increases then banks across the UK may wish to increase their rates too, so that they can charge more for borrowing money. This is also the same with savings interest rates; if the base rate goes up, you too could either make more money on your savings, or less if it goes down.

Why are interest rates so low?

Interest rates are usually low when there is a period of crisis or financial uncertainty (such as Brexit or Covid-19, for example).

The Bank of England may decide to dramatically decrease interest rates in order to encourage people to borrow more money, in order to boost the economy.

What do negative interest rates mean?

When interest rates become negative, it means that the interest rate has dropped below zero. This means that banks and building societies effectively have to pay to keep money in the banks, rather than earning interest on it from people borrowing money.

In terms of mortgages, if interest rates become negative, then you may end up paying back less than you actually borrowed.

How does inflation affect interest rates?

Inflation is directly correlated to interest rates and as one rises, the other usually decreases.

For example, if interest rates decrease, it usually means that more people are willing to borrow money as they’re able to pay back the money they borrowed at a lower rate of interest. 

On the other hand, if there is an economic boom and the economy suddenly starts to do well, then banks may increase their interest rates to discourage spending and borrowing in order to keep inflation down.

How will Brexit affect interest rates?

It’s difficult to predict exactly what will happen to interest rates with regards to Brexit.

In recent years, interest rates in the UK have dropped lower and lower, with the interest rate currently sitting at 0.1%.

It’s likely that interest rates will continue to remain low as a result of Brexit until things become clearer about what the future holds for interest rates and the economy in the UK in the aftermath of Brexit.

How do interest rates affect businesses?

Businesses are affected by interest rates in numerous ways.

Firstly, if interest rates increase, customers are less likely to purchase things from businesses as they will likely be too much in debt to have much disposable income. This means that businesses will lose money and may struggle as a result.

On the contrary, if interest rates decrease, people will generally have more money to spend, thus boosting the profits of businesses. 

The effects of increasing interest rates

There are several effects of increasing interest rates; we’ve outlined some of the most common impacts on increased interest rates below:

  • People may become discouraged from borrowing money if interest rates are increased as they know they’ll have to pay back more money. People who already have loans and are paying interest on them will have even less disposable income as they will now have to pay even more in interest.
  • An increase in interest rates will likely mean that people will have to pay higher interest payments on their mortgages, so they too will have less disposable income.
  • On the other hand, high-interest rates will mean that more people will look into high-interest savings accounts so that they can make the most out of their money.
  • When interest rates increase, it can sometimes result in reduced confidence from businesses and investors as they will be less likely to take risks with their investments if they’re worried about higher interest rates. 

Best interest rates current accounts

Having a high-interest current account is an increasingly popular way of obtaining more money and these kinds of accounts can sometimes be even better than some savings accounts.

The best interest rates in terms of current accounts depend on exactly what you’re looking for, so you need to ensure that you carry out plenty of research before committing to switching bank accounts.

If you are looking for a new current account with a high-interest rate, take a look at some of the UK’s best options below. 

  • Nationwide
  • Bank of Scotland
  • Santander
  • Lloyds Bank
  • Starling Bank

Interest rates are a complex and extensive financial matter to understand and while you don’t have to be completely aware of everything that interest rates entail, it is a good idea to have a basic understanding of some of the ways that interest rates can impact you, especially with regards to mortgages, savings and credit cards.

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