Interest rates: what are they, and what causes them to change?

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Interest rates are an expected part of finance. We want them high when saving and low when borrowing, but what actually causes them to change? How big of an impact do they have? With the economy shifting we have begun to get so much news around why interest rates are going up, discussions about the best rates and what it means for mortgages. It can all be a little confusing and overwhelming.

At Aro, we don’t want any part of finance to be confusing. We like to keep things straightforward so that you have the knowledge to get the best out of your finances. That’s why we’ve put together this handy guide on interest rates to help you better navigate your financial decisions.

What are interest rates?

Interest rates are used to show how high the cost of borrowing is, or how high the rewards are for saving money. They are measured as a percentage per year, and even a small increase can have a big impact.

Borrowing money

  • Interest rate is the amount you are charged for borrowing money
  • Measured as a percentage of the amount you borrow
  • Borrowing more means a higher total cost (borrowed amount + % interest)
  • Credit score and financial situation influence the rates offered

Saving money

  • Interest rate is how much extra will be added to any savings
  • Measured as a percentage of the amount you save
  • Saving more means a bigger boost is added (saved amount + % interest)
  • How you save and the amount you save will influence the rates offered

So, what is an APR?

APR stands for annual percentage rate of charge. While an interest rate simply tells you the cost that will be applied to your borrowing in the form of interest, an APR shows you the total charge for your borrowing over a year, taking into account any additional fees or charges.

For instance, if you were to take out a credit card with a purchase rate of 18.9% and a monthly fee of £3, the card’s representative APR would be 24.7%. APRs are used to show the cost of borrowing as it gives you a more complete picture of how much a loan or credit card will cost you, making them easier to compare.

Why do interest rates matter?

Interest rates aren’t just tied to our own finances – they reflect the economic health of the country as a whole. The economy should grow with the country – but at a controlled rate. This is inflation and the government has a target to keep it around 2%, meaning goods should cost 2% more each year. Interest rates are one way this is controlled.

They are tied to what is known as the Bank Rate (sometimes known as the base rate), which is a key interest rate set by the Bank of England. This influences all other interest rates in the country, is updated frequently throughout the year and can be a good marker of how interest rates are changing. You can see below some of the ways the country can be influenced by shifting interest rates.

What happens when interest rates rise?

  • Borrowing money can become more expensive
  • People looking for credit may receive less offers
  • Saving money is encouraged and more beneficial as you’ll get a better return on your savings
  • The cost of living is likely increasing faster than the average
  • Variable rate loans such as mortgages will cost more per month

Whilst it might feel unfair, raising rates isn’t just about companies earning more profit. Intentionally increasing interest rates slows the rate of inflation, and encourages people to reduce the amount they spend or borrow. This helps slow how quickly money is spent across the country, in turn slowing how quickly the price of goods increases.

What happens when interest rates fall?

  • Borrowing money is cheaper and less restrictive
  • Lenders will be more open to offering loans to more people
  • Spending money is encouraged
  • The cost of goods is increasing less than the average, potentially falling in severe situations
  • Variable rate loans, including mortgages, will see monthly costs fall

The intention of these outcomes is to encourage people to spend more and put more money back into the economy, helping to get inflation and the standard rates back on track. In particular, this is used to prevent a recession, which is where economic activity of a country is not growing as needed, and could be harmful long term if left unchecked.

What do interest rates mean for you?

As a general rule, if interest rates are increasing it is to encourage people to save more and borrow less, to help people reduce the amount they are spending and to bring the rate of inflation down. Falling interest rates will encourage spending, encourage borrowing and help bring the rate of inflation back up to intended levels.

  • In practice, this means that rising rates are usually accompanied by a sense that the cost of living is getting higher, and vice versa
  • Increasing interest rates could cause loans to have higher interest rates than expected, or you could see higher rates from what you may previously have been offered
  • The options you are offered for borrowing may reduce as base interest rates get higher, and some lenders may restrict the range of credit scores they offer to.
  • Variable rate mortgages will change with interest rates, increasing and decreasing with the Bank Rate

When borrowing money, you should consider the interest rates carefully to ensure they do not cause you a problem later on:

  • Only borrow amounts that are appropriate for what you need, and plan out what the money is going towards so you don’t borrow more than you need
  • Ensure you borrow from an appropriate lender for you – some lenders specialize in lending to people with lower credit scores, for example
  • Mortgages on variable interest rates may see you pay more if rates go up, so make sure you can afford to have them change a little when buying or remortgaging
  • Try to make sure that the repayments are affordable through the full lifetime of the loan, as missed repayments will harm your credit score
  • Check if you are able to make early repayments or overpayments as these will usually save you money on interest, though there may be fees involved so make sure it is the best decision for you

When taking out a personal loan, most lenders will work with fixed rates. This means the interest rate is set at the start of the agreement and doesn’t change. This offers security should rates increase and prevents you paying more – something that will happen to variable rate loans such as mortgages.

If you’re looking to take out a personal loan, interest rates don’t have to be scary or confusing. We can help you check rates with a wide lending panel to make sure you get the right options to match your finances. Check your eligibility with a soft credit check that won’t harm your credit score, quickly and easily at Aro.

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