Interest rates are the cost of borrowing money from a lender, such as a bank.
Interest rates are set by the lenders and are generally expressed as a percentage on an annual basis of the total amount borrowed.
This is known as the annual percentage rate or APR.
The interest rate can be determined by the risk of the borrower, a high risk borrower would be given a higher rate and a low risk borrower a lower rate.
Interest rates also show how much return a person will receive for saving money in a bank account.
Central Bank base rates
A central bank handles setting the base rate for lending money to commercial banks.
The base rate is considered the most important rate as it often influences other interest rates within the economy.
When a Central Bank decides to increase the base rate it can then make it more expensive for a commercial bank to borrow from the Central Bank.
This will lead to commercial banks passing the cost onto their consumers by increasing their own rates.
Although commercial banks are free to set their own interest rates, they do often follow the Central Bank base rate.
The affects of interest rate changes
Base rates are determined by many factors, including the state of the economy.
When a Central Bank sets higher rates this often leads to the cost of borrowing increasing and so discouraging people from borrowing.
Other affects cause by increased interest rates are;
- Higher rates of inflation.
- Higher reserve requirements set by banks.
- Lower consumer spending caused by people choosing to save their money with higher returns.
- Higher increased rates can eventually lead to a contraction in the economy.
Standard Variable Rate (SVR)
The main rate most commonly used by commercial banks for lending to consumers.
In general commercial banks tend to follow the Central Bank base rate.
Since 2009 there has been a growing gap between the Base rate and the bank SVR where banks are no longer passing on full base rate cuts to their customers.
These are the rates paid by the banks to their customers for saving funds in a bank account.
There are two different types of accounts, current accounts and savings accounts.
Interest Rate on Current accounts are generally the lower of the two types of rates paid to savers (around 0.5%).
This is because current account savers have instant access to their savings and so banks will then need to keep more money in reserve.
Current accounts do not work out to be very profitable for banks.
Interest rate on savings accounts tend to offer much higher rates to savers (between 2-4%).
Savings accounts are generally difficult for savers to access their savings with banks due to limitations placed on them.
Because of the limitations it means banks do not need to hold as much money in reserve and so can lend out more money to other people.
Mortgage Interest Rates
These are rates applied to loans secured against the value of a house or other asset.
These rates tend to be relatively low because if the borrower defaults then the bank can legally take possession of the property.
There are three main types of rates offered by banks, Fixed mortgage rates, Tracker mortgage rates and Variable mortgage rates.
- Fixed Mortgage Rates are rates that are held at a certain percent over an agreed period of time.
Because the rates are fixed it gives holders greater security to rate rises.
- Variable Mortgage Rates are rate which are set by the banks SVR.
- Tracker Mortgage Rates are rates that follow the Central Bank base rate.
If the Central Bank reduces the base rates then the mortgage rate will also fall to a similar level.