Why do interest rates rise and fall?

Whether you’re a borrower or a saver (or both), a change in interest rates can have a big impact on your money. So, it really is something worth knowing a thing or two about.

To get you started, we’ve created this guide that will explain some of the reasons interest rates rise and fall, and how they can affect both you and the wider economy.

We’ll cover:

• Interest and inflation
• Why do interest rates change?
• When do interest rates change?
• Why are interest rates so important?

A quick introduction to interest and inflation

Before we get into the details, let’s look at the basics of interest and inflation.

What are interest rates?

Think of interest as the price tag on borrowing money. When you take out a loan, you pay it to the lender. On the other hand, when you save, you earn it from your bank.

Interest rates show how much interest you will pay or earn. They are expressed as a percentage. This percentage represents how much extra you’ll pay back on a loan or earn on your savings over a year.

What is the Bank of England base rate?

The Bank of England base rate is the interest rate the Bank of England (BoE) pays other banks and building societies that hold money with it.

Why is it so important? The base rate sets the tone for lending across the UK. Banks use it as a guide when setting their own interest rates. As a result, the BoE can indirectly influence whether customers are encouraged to spend or save. This influence can be used to manage the UK economy on the whole.

The base rate is set by the BoE’s Monetary Policy Committee (MPC). They meet regularly to adjust the base rate to keep the UK economy in tune.

Note: The base rate isn’t the only factor influencing the rates set by banks. They also consider things like risk levels when determining rates for loans and mortgages and the wider savings market when setting rates for savings accounts.

What is inflation?

Inflation is the rate at which prices for goods and services increase over time, typically measured annually. It’s measured as a percentage increase in prices. So, if inflation is at 10%, costs will have risen by 10% compared to a year ago. This increase means that your money won’t go as far as it had the previous year.

When we talk about the inflation rate rising, we aren’t talking about one or two goods getting more expensive, it’s a measure of the price increases right across the board. The UK uses the Consumer Price Index (CPI), which measures the average price of a representative “basket of goods” determined by the Office of National Statistics.

What causes inflation?

Inflation is driven by supply and demand. When demand is high and supply is low, then prices tend to increase. An imbalance between these two are, generally, caused by either a slowdown in the supply chain or when an economy has an increase in its money supply and people have more to spend.

Why do interest rates change?

Remember the BoE’s base rate? It’s a key tool for controlling inflation. When there is an increase or decrease in the base rate, it usually trickles down to rates offered by other banks.

The government sets an inflation target, aiming for a balance where prices rise gently alongside wages. This keeps the cost of living affordable and allows some economic growth. When the BoE’s MPC meets, they decide whether they need to change the base rate to try and meet this inflation target.

If the rate of inflation rises above or falls below the target, the MPC can decide to change the base rate. This then impacts interest rates across the UK.

However, it’s important to know that banks and building societies may also decide to alter their interest rates without a change in the base rate. They are constantly reviewing the economic, savings and borrowing environment to ensure that the rates they are offering reflect the current market.

When the rate of inflation rises

When inflation rises too much, the BoE can raise the base rate. This has a ripple effect as banks and building societies raise their own interest rates:

• Borrowing becomes pricier: higher interest rates mean you pay more to borrow money, discouraging excessive spending.
• Saving becomes more rewarding: higher interest rates on savings accounts encourage people to save their cash.

As a result, people tend to spend less and save more, cooling down demand and helping to tame inflation.

When the rate of inflation falls

When inflation is too low, the BoE can lower the base rate. Banks and building societies usually follow suit in lowering their own interest rates, leading to:

• Cheaper borrowing: lower interest rates make loans more attractive, encouraging spending and investment.
• Less rewarding saving: lower returns on savings accounts can nudge people to spend rather than save their money.

The result? People are less motivated to keep hold of their money, which increases borrowing and boosts spending. This gives inflation a gentle nudge upwards.

When do interest rates change?

Interest rate changes as a result of a base rate change generally happen after the MPC has made the decision to alter the base rate. They meet roughly every six weeks (eight times annually), so it’s possible that a rate change could happen at any time of the year.

That being said, it’s worth remembering that banks and building societies may decide to adjust their interest rates on their own without any change in the base rate. So, it’s not uncommon for an interest rate to change at any time.

Why are interest rates so important?

Interest rates aren’t just numbers discussed by economists. They have a real impact on your daily life and financial well-being. Changes in interest rates can affect many parts of your financial life, including your:

• Savings: how much you earn on your saved funds.
• Mortgage: your monthly repayments.
• Loans: the cost of borrowing.

Understanding how interest rates work empowers you to make informed financial decisions, especially in times of economic uncertainty.

Your savings can benefit from higher rates

High interest rates are a saver’s best friend. When rates are high, your money is more likely to grow faster thanks to increased returns on your savings accounts. It’s a great time to prioritise saving and watch your nest egg flourish.

But not all savings accounts are created equal. Remember to take time to shop around and compare interest rates and terms from different banks and building societies. If you don’t really know where to start with savings, read our how to save money guide first.

During times with low interest rates when your returns might be lower, saving can still be a smart move for financial stability. You may wish to consider a fixed-term savings account, like our Fixed Saver, that allows you to lock in a decent rate for a set period, protecting your savings from potential rate drops.

Borrowing can be expensive when interest is high

High interest rates make borrowing more expensive. Whether it’s a mortgage, personal loan, or credit card, you’ll pay more in interest charges. You may want to think carefully about whether you can afford to take on new debt when rates are high.

On the other hand, periods of low interest can be an advantageous time to borrow. For example, you might be able to secure a low fixed rate for an extended period, providing stability and predictability. However, always take care to borrow responsibly and ensure you can comfortably afford repayments, even if interest rates rise in the future.

Rising interest rates can affect your existing borrowing, especially those with variable rates. Your repayments could increase, impacting your budget. It’s worth factoring this possibility into your financial planning.

Changing rates can impact your mortgage

Should you have a mortgage, it may be closely tied to fluctuations of interest rates, especially if it has a variable rate.

When rates rise, your monthly payments could rise, putting a strain on your budget. Conversely, when rates fall, you may enjoy lower payments, freeing up some cash flow. If you’re within a fixed rate mortgage period, your monthly payments will remain stable regardless of interest rate movements.

Many people consider interest rates when they are deciding whether they need to remortgage or not. For instance, if you’re coming to the end of your fixed rate period, you may be tracking rates to see if it’s a good time to remortgage or complete a product transfer to lock in a better deal. Or, you may prefer to take advantage of your lender’s variable rate if interest rates are low.

To get a better understanding, we recommend reading our remortgaging guide and guide to the benefits of remortgaging for more information.

Changing interest rates impact first time buyers

If you’re considering applying for a mortgage, understanding interest rates is crucial. Here are a few things you should be aware of before deciding if it’s the right time to submit your application:

• Fixed vs. variable rates: fixed rates provide stability with predictable payments, while variable rates fluctuate with the market, offering potential savings but also potential increases.
• Current market conditions: are rates currently high or low? This can influence the type of mortgage you choose and the overall cost of borrowing.
• Future expectations: where are interest rates forecast to go? Consider this when deciding between a fixed or variable rate.
• Affordability: can you comfortably afford repayments, even if interest rates rise? Factor in potential increases when budgeting.

If you’ve got mortgages on your mind, you’ll find lots of guidance on our mortgage knowledge hub, including a first time buyer guide and tips on getting the best rate.

We hope you found this guide helpful and that we’ve de-mystified interest rates for you. Yes, they can be a complicated topic, but it’s really beneficial to get an understanding of them to boost your own financial education.

Don’t forget, we’ve got a range of savings and mortgage products, as well as business loans, that could help you to improve your financial wellbeing.