Understanding Interest Rates

March 13, 2019
Taryn Lee-Johnston

Interest rates can genuinely be very interesting and it can certainly pay to understand what they are and how they work.  With that in mind, here is a brief guide to what interest rates mean in practice.

Interest rates are a tool to control inflation

The Monetary Policy Committee of the Bank of England has been charged by the government to keep the rate of inflation at 2%.  If inflation looks to be rising above target, the Bank of England can raise interest rates to make it more attractive to save money instead of spending it (and more expensive to borrow it), whereas if inflation looks to be falling below target, the Bank of England can lower interest rates (or use quantitative easing) to make is less attractive to save money (and cheaper to borrow it).  As the Bank of England is a central bank, the rates it sets only apply directly to the banks with which it does business, but the interest rates set by the Bank of England will influence the interest rates set by its customer banks, which is why the rate set by the Bank of England is known as the base rate.

From base rate to retail rate

The base rate is, essentially, the benchmark rate, which retail banks can use as a guideline for their own pricing decisions.  In terms of attracting savers, banks can offer different rates of interest depending on the profit they expect to make from lending out the cash deposited with them.  So, for example, a flexible savings account might pay very little interest because the bank has no guarantee how much money is going to be left in the account for how long.  By contrast, if a saver agrees to leave a certain amount of money in the account for a certain length of time, they may be rewarded with a higher rate of interest.  When it comes to lending money, banks are essentially looking to find the right balance between risk (the possibility of the borrower defaulting) and reward (the money they can earn from interest payments made by the borrower).  There are various criteria they will use to determine this, such as the purpose for which the loan is being made (for example is it for the purchase of an asset, which could be sold to pay back the lender if the need should arise), the flexibility with the repayment schedule (for example a low-interest loan may require the capital to be repaid within a certain time whereas a higher-interest credit card might only require minimum payments to be made) and the borrower’s personal situation.

The individuality of interest rates

One of the key points to remember about interest rates is that the fact that a bank can offer a certain interest rate for a certain product does not mean that they will offer that interest to everyone.  They may offer you the same product but at a different rate of interest or they may decline to offer you the product at all.  Therefore, before even applying for any sort of credit, it can be useful to look at the situation from the perspective of a lender and ask yourself the sort of questions they are likely to ask.  As previously mentioned, in addition to looking at the purpose and nature of any loan, a lender will also take a close look at the potential borrower by means of their credit rating, hence it makes sense to do everything you can to get it looking good, especially if you wish to borrow a large sum of money, for example to buy a house.