What does the base rate increase mean for your debts?
What does the base rate increase mean for your debts?
This week, the Bank of England has increased the base rate from 0.25% to 0.5%. This is particularly interesting because this is the first time that the base rate has been increased in just over ten years.
What is the base rate?
The base rate, also known as the interest rate, or the bank rate, is the interest rate at which banks borrow from the Central Bank of the UK – the Bank of England. This rate then influences how the interest rates on the products provided by the banks, such as loans and mortgages. This is because the higher the base rate is, the more money the banks have to pay to the Bank of England, so the more money they have to charge consumers to make a profit.
The rate also determines the savings rate that the Bank of England offers banks to deposit money into them. Similarly, this influences the savings rates they then offer to customers, because the more money they can make from depositing into the Bank of England, the more money they can afford to offer their customers for banking with them.
Why is it increasing?
Normally, interest rates rise when the economy is doing very well, or, more specifically, too well. However, this rate rise is due to the announcement that September’s inflation rate reached 3%.
Inflation is the amount that prices rise at any given time, so prices in September 2017 are 3% more expensive than they were in September 2016. It helps define how much your money is actually worth. For example, if you had £100 in September 2016 and you could have bought 100 apples with that money, now you can only afford 97 apples with that £100.
By increasing the rate, the Bank of England is hoping to encourage people not to take out loans in order to spend, but to save instead. If people chose to save instead of spend, demand goes down, which encourages a reduction in prices and lowers inflation.
What does this mean for your loans?
Essentially, the interest that you pay on your loans is very likely to go up.
Imagine your local bank borrowing £10,000,000 from the Bank of England. Last week, they would have had to pay back an extra £25,000 (0.25%) on that loan. This meant that when they lent money to their customers, they need to make sure the interest rate was enough for them to pay the costs of running their bank (their employees pay, their rent, their utilities, etc), make a profit, and earn £25,000 to give back to the Bank of England. To do this, they might use the loan to give out 1,000 loans of £10,000 at 5% interest to their customers. This would make them £10,500,000. After they return the loan, plus 0.25% interest, they are left with £475,000 to spend on running their bank, and as profit.
But, from this week, when they want to take out £10,000,000, the Bank of England will charge them 0.5%. This means they have to pay back an extra £50,000, rather than £25,000. To make sure that their profits don’t decrease, banks will raise their interest rates accordingly, so those 1,000 loans of £10,000 may now have interest of 5.25%, 5.5%, or, possibly, higher.
The same thing happens to your mortgage as long as you are on a ‘rate tracker’ mortgage. Some people are on ‘fixed rate’ mortgages, and these will not be affected by a rate increase. However, it is important to note that a lot of ‘fixed rate’ mortgages are only fixed for a limited period of time, such as two years. This means that when your ‘fixed rate’ ends, your interest is very likely to increase.
For those on a ‘rate tracker’ mortgage, you will see an increase in your monthly payments. The average person is expected to experience a £22 monthly increase. However, the amount that your mortgage increases depends on the value of your mortgage, your interest rate, and how much your bank wants to increase the rate.
But is there any good news?
If you are lucky enough to have savings, then there is some good news, the interest rate could affect your savings accounts.
A lot of people, in recent years, have noticed savings accounts offering lower, and lower, interest rates. Considering the recent rise in the inflation rate, this is a problem. If inflation is 3%, but your savings have a return of less than 3%, your money is losing value.
Saving £10,000 at about 2%, will mean that you could earn about £200 over a year. This means that you end up with £10,200. However, if inflation is at 3%, your £10,200 is still worth less than the £10,000 you started out with. If we use our apple example again and £10,000 in Year 1 buys you 10,000 apples, but the £10,200 in Year 2 only buys you 9,894 apples. In order to buy 10,000 apples in Year 2, you would need £10,300.
So, by increasing the base rate, the Bank of England is encouraging high-street banks to offer higher interest rates on savings to prevent your money losing value.
Just a theory
Unfortunately, most of what has just been described is, largely, theory. As anyone who has needed a loan in the past few years has noted, interest rates for loans are very high. According to the theory described above, interest rates for loans should have been very low over the last decade because the Bank of England was not charging banks much for their loans. However, banks have, instead, been charging a lot so that they can make as much profit as possible.
This makes it likely that interest on loans will go up, as banks will want to continue making their big profits. However, it is less certain that savers will feel the benefit of an increased bank rate.
Banks could chose to simply pocket the money they make with the extra 0.25% bank rate, instead of passing savings on to the consumer. In reality, what will decide whether interest on savings will go up is the competition between banks to attract customers. If very few banks, or none at all, offer a higher savings interest rate, then there is not much competition and no need to offer high savings rates to attract customers. However, if enough of them decide to offer high savings rates to attract customers, all the banks will be forced to do the same in order to stay competitive and not lose their customers.
If you need more information about the options available to you in dealing with your debt, you can always speak confidentially with one of our friendly advisors on 0808 2085 198.
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