How interest rate changes affect your finances
Interest rates, whether they are rising or falling, can have a significant impact on your finances and investments. We explain what you need to know.
What you'll learn:Click to toggle accordion What you'll learn:
Why interest rates change.
How rising rates affect your finances.
What impact falling or low interest rates can have on your investments.
The Bank of England’s Monetary Policy Committee (MPC) will meet on 10 May to decide whether the base rate, currently 0.5%, will change or remain the same.
Many forecasters believe that the weakest UK growth figures for five years have made it much less likely that rates will increase this month. The economy grew by just 0.1% in the first quarter of this year, according to latest Office for National Statistics data, much lower than the Bank of England’s 0.3% prediction.1
Prior to the release of the growth figures, economic forecasters the EY ITEM club, predicted that the Bank of England would raise interest rates gradually, with two hikes in 2018 bringing the base rate to 1% and one further hike in 2019 to 1.25%.2
However, no-one knows for certain how rates will move in months to come, so it’s important to consider the impact both of rates moving and staying unchanged.
At the height of the financial crisis in March 2009, the Bank of England cut interest rates to 0.5% in the hope that cheaper borrowing costs would spur on more spending and investment and therefore help prop up Britain’s economy.
They stayed at this level until August 2016 when, following the UK’s decision to exit the European Union, policymakers decided to take cost of borrowing down even further, to a new all-time low of just 0.25%. Rates then increased by a quarter of a percentage point in November last year to 0.50%, the first rate increase since July 2007.3
Why do interest rates change?
The nine-member MPC is responsible for setting interest rates in the UK. When it alters the bank base rate, it does so to try and influence economic activity and keep the supply and demand for goods and services roughly in line with each other. It does this with the aim of keeping inflation on track to meet its 2% target. If demand for goods is greater than supply, inflation typically rises above this target and vice versa.
How rising interest rates could affect you?
Typically policymakers will hike interest rates when inflation is on the increase, or at least is likely to rise markedly. As such, rates will be raised in order to take some steam out of the system in order to lower demand and cool the pace of economic expansion.
The clear impact of higher rates is that borrowing money becomes more expensive. Interest payments on credit cards and personal loans for example will all typically rise and as a result consumers and businesses will feel the pinch of steeper costs. Higher interest rates also mean that people with mortgages pegged to the base rate will have to fork out more to cover their repayments, which will ultimately eat into their disposable income.
Overall the economy will probably experience a drop in investment and consumer spending as belts start to be tightened. For example, consumer discretionary companies - firms that sell non-essential products could see their share prices fall as consumers cut back on spending.
By increasing interest rates, the Bank of England also strengthens the value of sterling - therefore UK exports become less competitive for overseas buyers, which can hit the trading of British firms selling their products and services overseas. On the other hand, the price of imports may fall, thus reducing the cost of living.
However, higher interest rates can be beneficial for the financial services sector especially banks, as they can increase interest rates on loans. Of course, higher interest should be reflected in cash accounts and as such any tightening, is likely to encourage more people to save as they can get a higher return.
But while rising interest rates can knock confidence and discourage firms and consumers from investing, it is worth bearing in mind that if interest rates are raised, it should hopefully be because the wider economy is growing and is therefore able to withstand any monetary policy tightening.
Will Hobbs, Head of Investment Strategy at Barclays Wealth and Investments, said:
“Asset markets around the world are expecting interest rates to rise to some degree in the major developed economies over the next several years, including the UK."
"In theory, rising interest rates should mean lower equity market valuations, because interest rates are used to discount future cashflows back to a present value. However, interest rates tend to rise in a world where growth expectations are rising too, which is typically good for profit growth expectations and therefore equity markets."
"It is worth remembering that UK interest rates are not central to a globally diversified investment portfolio’s performance. More important is what happens in the US economy and its capital markets, as this still provides the lead for the rest of the world."
What impact do falling or low interest rates have on investments?
Low interest rates are bad news for savers as rates paid on deposit accounts are usually cut back in response. Low interest rates do however make it cheaper to borrow money. In theory at least, this should encourage both consumers and corporations to borrow, spend and invest more. This in turn can potentially lead to stronger economic growth, higher share prices and rising inflation, as more money is pumped into the economy.
A backdrop of benign monetary policy means that consumers with mortgages linked to the base rate will enjoy smaller monthly mortgage payments, and therefore a greater level of disposable income. It can also spur on people to take out a loan for more big-ticket purchases, such as a new home or car.
Overall this environment can help drive up share prices, especially those of companies that rely heavily on consumption.
Lower interest rates also mean a weaker pound and for UK firms that earn much of their money in foreign currencies, this can prove very beneficial as a drop in the value of sterling makes UK exports more competitive. But equally, this scenario also means imports may become more expensive, therefore raising the cost of living.
A low or falling interest rate environment can also help to boost bond prices too, as bonds have an inverse relationship to interest rates. In other words, when interest rates rise bond prices tend to fall because the fixed rate of interest they pay becomes less attractive to investors but when the cost of borrowing eases, prices typically rise because the fixed rate of interest they pay becomes more attractive to investors.
Remember, the value of investments can fall as well as rise, regardless of where interest rates are, and you could get back less than you invest. If you’re not sure about investing, seek independent advice.
Remember, the value of investments can fall as well as rise and you could get back less than you invest. We're not recommending Ready-made Investments as being suitable for you based on your personal circumstances. If you're unsure about this investment’s suitability for you, you should seek independent advice.
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