What Are Interest Rates?
Updated: Aug 20, 2021
Interest Rate Meaning
Interest rate is the percentage you earn when saving or charged when borrowing. They’re controlled by the central monetary authority. Borrowers are charged on the amount they borrow. For example, if you own a mortgage you pay the interest on the loan, the interest rate can affect these interest payments. Savers earn the interest rate on invested money. For example, if you have money sitting in your bank then you will earn interest for leaving it there.
Changes in interest rates heavily influences economic activity, for example dovish interest rates tend to increase economic activity whereas hawkish interest rates cap economic activity.
Definition and Examples of Interest rates
The interest is what the borrower pays for borrowing money, and what the bank pays the saver for saving money. Interest rates will always be shown as a “percentage of the amount you borrow or save over a year”.[1]
For example, if you saved £100 in a savings account with a 1% interest rate, by the end of the year you would gain £1.
The most important interest rate is the “bank rate” also known in the UK as the “Bank of England Base Rate”. This is the interest rate that is talked about in the news whenever there’s a major interest rate change.
The monetary policy committee (MPC) sets the bank rate in the UK, in the United States the Federal Open Market Committee (FOMC) would set the interest rates. This Bank Rate determines the interest rate the Bank of England pays to commercial banks that hold money with them, which then influences how much the commercial banks charge people to borrow money or pay on savings.
The Bank Rate in the UK can fluctuate depending on economic conditions and the goal of the monetary policy set by the MPC is to keep inflation low and stable at “2%”.[2]
How Interest Rates Work
Interest is charged by the lender to a borrower for the use of an asset. Cash, vehicles and property are the most common assets lenders will charge interest on. For example, if you borrow cash as a loan you will be charged interest over a period of time.
The most common form of interest an average person will pay is a mortgage on a property they want to buy, since most people can’t outright purchase a property they use a mortgage to borrow the funds necessary to pay for the property and pay the loan off over time with interest.
How Interest Rates Are Set
The interest rates themselves will be changed by the central authority depending on a number of factors such as current levels of inflation and what state the economy is in. When a central bank increases the interest rates the cost of borrowing rises. When the cost of borrowing is high this then discourages borrowing and slows overall demand. For example, if interest rates are really high and you were thinking about taking out a loan it now costs much more to repay the loan with interest on top so you save the money instead.
Central banks will generally increase interest rates when inflation starts to rise too quickly.[3]
This is because the central bank doesn’t want prices in the economy to outpace wages so to stop the economy from overheating it tries to reduce overall money supply to bring inflation down to maintainable levels.
Economic contractions or recessions can have the opposite effect on interest rates. When economies are faced with slowed economic growth Central banks will opt for a Dovish approach to interest rates, reducing interest rates to stimulate the economy. This increases the money supply, making borrowing cheaper and increasing demand in the economy.
What does It Mean for Retail Investors
Retail traders and investors must keep a close eye on interest rates, how they’re set and how it not only affects the economy but the instrument they’re looking to trade. For example, high interest rates can be bearish on stocks but bullish on the base currency that the interest rate was set.
Article Sources
Bank of England, “Interest rates and bank rate”, https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate.” Accessed August 05, 2021.
Bank of England “Inflation and the 2% target”, https://www.bankofengland.co.uk/monetary-policy/inflation. Accessed August 05, 2021.
Federal Reserve, “ Monetary Policy”, https://www.federalreserve.gov/monetarypolicy.htm, Accessed August 07, 2021.
