How Are Interest Rates Set?

Dave Beard

Written by Dave Beard on March 20, 2019

Updated May 9, 2019

interest-rates

Interest rates affect all of us, whether we borrow money from a bank, carry a balance on a credit card, or have a savings account. When we borrow money, we pay interest on our repayments, calculated as a percentage of the total amount we owe. When we have savings, we are paid interest by the bank, calculated as a percentage of how much we have in our account.

These rates are set by individual lenders and vary depending on who you’re borrowing from or saving with. In general, however, banks, building societies and other financial institutions calculate the rates based on the Bank of England base rate.

What is the Bank of England Base Rate?

The Bank of England base rate is an interest rate set by the bank’s Monetary Policy Committee (MPC). It is applied to any money held by the Bank of England on behalf of commercial banks and paid in just the same way you would be paid for interest on your savings. Commercial banks use this rate to set the interest they charge lenders or pay savers.

While the interest commercial banks pay savers tend to closely reflect the Bank of England base rate and tends to be set for all savers opening an account, the rates they charge borrowers aren’t set as close to the base rate. In addition, they can vary significantly between borrowers based on an individual’s credit rating.

What does the Monetary Policy Committee do?

The MPC meets every six weeks (approximately) to review the UK economy and decide if changes to the base rate are needed to stimulate the economy or ensure inflation remains low (the Government has a target of 2% for inflation). Once they have met, the MPC announce any changes to the base rate; after this, banks may make changes to their interest rates.

Not everyone will see a change to their interest rates. For example, if you have taken out a personal loan or mortgage on a fixed rate, this will not change even if their lender then changes the rate applied to the loans they have available.

If, however, you have a tracker mortgage, which is linked to the Bank of Interest base rate, you would see a change almost instantly which could lead to an increase or decrease in your payments depending on whether the base rate went up or down.

What else affects interest rates?

Banks and other financial institutions charge interest because they need to cover their costs and – remembering they’re commercial businesses – make a profit. This means they need to make more on lending than they pay out on savings.

To do this, they set interest rates on savings close to the Bank of England base rate, while interest rates on borrowing is set at a higher rate. The difference is their profit.

Banks need to find the balance between interest rates on savings and borrowing in order to remain competitive against other banks and maintain (or grow) their customer base. When setting interest rates, therefore, they take both the base rate into account and the interest rates set by their competitors.

Tip: When it comes to borrowing, banks look at an individual’s credit rating as well; the better your credit rating, the more likely you are to get a rate that matches or is close to the representative APR banks use when advertising loans.

The wider impact of interest rate changes

One of the driving factors for the Bank of England in setting the base rate is keeping inflation as close to the Government target of 2% as possible. Interest rates impact inflation because they impact our spending. If the base rate is lowered, for example, and your bank lowers the interest on your tracker mortgage. As a result, you will have more money to spend (or save).

Having more money in your pocket might be a good thing for you, but if there is too much money circulating in the economy, it could lead to inflation, meaning things will cost more. In order, therefore, for the Bank of England to keep inflation at the right levels to support economic growth, they need to find the balance between encouraging people to spend and save. They do this through the base rate, and the anticipated effect this will have on interest rates.

The effects of interest rates on the economy could be seen after the financial crisis of 2007/8. Because people were unsure of what was going to happen to their jobs, they stopped spending, leading to businesses closing and having to lay off workers. The Bank of England reduced the base rate so that banks would reduce their interest rates and people would have more money to spend, and it would be less beneficial for them to save. This led to an increase in spending, which helped drive economic growth.

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