How interest rate changes affect your finances

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 base rate is the Bank of England's official borrowing rate, the interest it charges other banks when they borrow money. In turn this affects what interest borrowers pay their lenders, so it’s important to understand the impact of interest rates moving upwards, downwards or remaining unchanged.

Why do interest rates change?

The nine-member Monetary Policy Committee is responsible for setting interest rates in the UK. When it alters the Bank of England base rate, it does so to maintain economic growth and inflation at a stable rate.

How lower interest rates could affect your investments

Savings rates tend to fall in response to an interest rate cut, unless you have your money in a fixed rate account. The worry is that with rates so low, savers might stop saving altogether.

And anyone choosing to use a pension pot to purchase a standard annuity – an income for life – will usually get less income for their money when interest rates drop.

Mortgages should get cheaper. Most borrowers with tracker mortgages should see their bills fall as their repayments drop in line with a base rate cut – although a few may find they have a deal where the reduction is less than the base rate cut or a floor is applied to how low their loan rate can go.

Homeowners paying a lender’s standard variable rate may also see their repayments drop – but it’s up to individual lenders as to when or even if they pass on the cut. Those with fixed rate home loans will continue to pay the same until their deal ends. However, borrowers might see the cost of new fixed rate mortgages falling to reflect the cheaper cost of borrowing.

Low borrowing rates should in theory encourage both consumers and corporations to borrow, spend and invest more. This in turn can lead to stronger economic growth, higher share prices and rising inflation, which can help drive up share prices, especially those of companies that rely heavily on consumption.

The pound and stock markets are also affected by rate changes. Though the falling pound means you pay more for your holiday money, it can be a boon for UK firms that earn much of their money in foreign currencies. This is because a drop in the value of the pound makes UK exports more competitive. But equally, imports may become more expensive, therefore contributing to a higher cost of living.

A low or falling interest rate environment can 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.

Find out more about bonds

How higher interest rates could affect your investments

Raising interest rates is how the Bank of England can help to get inflation back down. Any increase would filter through to interest payments on credit cards and personal loans. As a result, consumers and businesses would face steeper costs.

Higher interest rates also mean that people with mortgages linked to the base rate would see repayments rise.

At that point there could be a drop in both investment and consumer spending as the nation tightens its belt. For example, consumer discretionary companies – firms that sell non-essential products – could see their share prices fall as consumers cut back on spending. A higher savings rate also encourages more people to save.

By increasing interest rates, the Bank of England typically strengthens the value of the pound. This means UK exports become less competitive for overseas buyers, which can hit the trading of British firms selling their products and services overseas. On the plus side, the price of imports may fall and help reduce the cost of living.

Higher interest rates can be beneficial for the financial services sector, especially banks as they can increase interest rates on loans.

Higher interest rates are not always to be feared, as they can be a sign that an economy is doing well.

Will Hobbs, Chief Investment Officer at Barclays Wealth and Investments, said: "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."