What are interest rates?

Interest rates are a key weapon in the arsenal of Central Banks, but their impact can be felt much further afield than the Bank of England’s home on Threadneedle Street. As global economies attempt to grapple with the impact of COVID-19, it’s important you understand how interest rates affect your money.

Whenever you borrow money, you expect to pay interest on your loan – whether it’s on your credit card, your mortgage, or even your student finance. This interest is essentially the cost of being able to spend now, instead of spending months saving up.

For the lender, it acts as a reward for taking on two principal risks; time and potential default.

How do interest rates work?

Money is loaned on the premise that it will be repaid. However, there is always a risk that a borrower will default on this repayment. This risk is calculated in the interest rate along with the risk of inflation.

Inflation reduces the purchasing power of money over time. This means that if a lender loans out £1,000 for one year and inflation is at 2%, the real value of that money will have fallen to £980 over 12 months. The rate of interest lenders charge factors this into the calculation.

Interest is usually expressed as a percentage of the amount you have borrowed. For example, say you took out a £10,000 loan for one year, with a 3% interest rate. You’d pay an extra £300 on top of repaying the initial £10,000. However, when you factor in compounding, the amount you pay in interest may rise.

Why do Central Banks cut interest rates?

Central Banks adjust interest rates to try and keep inflation in line with the targets set by the government – it’s currently sat at 0.1% in the UK in response to the recent crisis. 

This bank rate feeds through into the interest rates offered by high street banks and building societies, and influences the rates offered by other lenders too.  

When Central Banks want to stimulate the economy and encourage spending, they might lower interest rates (as they have done recently) to make borrowing more appealing and saving less attractive. With an appetite to spend, the higher demand for goods and services will cause prices to rise. The rate of this price growth is measured by inflation.

If inflation gets too high, Central Banks might want to unwind some of this economic momentum to ensure the economy doesn’t overheat. By increasing interest rates, borrowing will become more expensive and saving will become more attractive – although by how much depends on the size of the rise.

Central Banks also use quantitative easing to try and stimulate the economy – where they create money to buy investments like government bonds.

Negative interest rates

During deflationary periods, people tend to save money rather than spend it. This lack of demand for goods and services causes prices to fall, which over time forces companies to scale back their operations. This can lead to an increase in unemployment, which reduces the scope for spending in the economy further.

Cutting interest rates to zero in this environment might not be enough to stimulate the economy. Instead, banks (albeit rarely) use an unconventional tool to deter saving: negative interest rates.

Instead of earning a return on the money sat in cash accounts, savers will be charged to keep it there. In 2014, the European Central Bank introduced negative interest rates to bank deposits to try and prevent the economy from slipping into deflation.

Interest rates and bonds

A bond is a debt investment; when an investor buys a bond they instantly become a lender, loaning money to a corporation or government.

The scope for potential returns from a bond is limited; you’re repaid what you loaned and you get an income from the coupon interest. An investor will calculate their potential annual return by measuring the yield – the interest dividend by the value of the bond.

Knowing the important impact interest has on investor return, it’s crucial to know how interest rate changes affect the bond market. Interest rate rises cause current bond prices to fall, while interest rate falls cause bond prices to rise.

If interest rates rise, an investor can expect to receive a higher coupon on their bond in the future, and will prefer to buy the newer bond to get the best return possible.

As a result, bonds that have already been issued will fall in value, as investors look elsewhere for their income. As bond prices fall, the yield will increase, making it more attractive to the investor. The opposite can be expected when interest rates fall.

Interest rates and equities

Interest rates usually support the equity markets. If consumers are encouraged to spend more, prices will rise. Inflation will drive company earnings higher, as long as wages grow in line, which will be reflected in more expensive prices on the stock exchange.

Some of these profits will be reinvested back into the business to scale up operations, which will decrease unemployment and fuel the whole process.

How do interest rates affect currency?

In general, higher interest rates tend to increase the value of that country’s currency. If the Bank of England were to increase the bank rate, foreign investors would find sterling more attractive and an increase in demand would push up its price.

Unfortunately, the economy is rarely that simple, and the relationship between interest rates and inflation complicates matters. Other factors also hold greater sway over the value of currency; like political strain and health of an economy.

After nearly a decade of low interest rates, it’s important Brits understand the impact interest rate changes can have on their money. Being aware of these traditional dynamics between the economy and financial markets means you can diversify your portfolio to try and manage these risks appropriately.

Photo by Patrick Tomasso on Unsplash