Interest rates are a feature of many financial service products: from ones that pay you, like savings accounts and some investments, to ones that cost you, like loans and credit cards.
One thing is for certain, you’re sure to come across them again in the future – so it pays to know what you’re looking at.
Interest rates are notoriously difficult to get to grips with, so we’ve found the five most common questions people have and we’re going to answer them in this blog, using plain English.
1. What is an interest rate?
Essentially, the interest rate is the “price” of money. If you are saving it is the price you will get paid for “lending” your money to the bank. And if you are borrowing, the interest rate is the cost of borrowing. The rate itself lets you know how much that cost will be. The higher the rate, the more you’ll be required to pay to borrow.
If you take out a loan, for example, you would have to repay what you borrow plus interest. Let’s use a quick example. Taking out a loan of £500 with an interest rate of 10% means you would have to repay the full £500 back plus £50 in interest.
2. Who sets interest rates?
The Bank of England set the base rate of interest – which is currently at a low rate of 0.5%.
Individual lenders (whether that be of loans, credit cards, mortgages or overdrafts) will set their own rate of interest. Whilst they may or may not be explicitly linked to the Bank of England’s base rate, it’s fair to say that the higher the base rate, the more you will usually pay to borrow. However, interest rates on borrowing are also determined by what sort of borrower you are. For example, borrowers that are seen as high risk will pay more than those that are seen as low risk.
3. What does the base rate actually do?
The Bank of England tries to control the economy using “monetary policy”. If the economy seems to be overheating then prices will start to rise faster – which is called inflation. The Bank will increase interest rates to try to stop this from happening. If the economy slows down it will cut interest rates. The government has asked the Bank to keep inflation at no more than 2% so that’s the target it has to aim for.
4. What is inflation?
Inflation is a way of measuring how much prices of goods and services change over a period of time. The Office for National Statistics measure the rate of inflation in the UK once a month.
This is important as the rate of inflation affects the actual value of money. If the inflation rate is high, over time the purchasing power of your money reduces. This can cause big problems unless incomes rise in parallel with inflation.
5. Do all customers get the same interest rates?
If an interest rate is displayed as APR representative or APR typical, it means that not everyone that applies will be charged the advertised interest rate. This is because the actual interest rate you receive depends on a number of factors, including your credit history.
At least 51% of the people that apply and are accepted for a personal loan or credit card will be offered the advertised rate, where the rest may get a different rate – which is usually higher. With a secured loan, this advertised rate must be offered to at least 66% of the people that are accepted.
People with patchy credit histories may be more likely to get a higher rate, where those with near-perfect track records could receive cheaper rates. But, your credit history isn’t the only thing that may affect the interest rate you are charged. The amount you borrow and how long you borrow for could also affect the interest rate you are charged.