Interest Rates: what are they & why do we need to pay attention?

Mike Younie

There has been a lot of talk about interest throughout the media this year and the possibility of rates rising for the first time in 6 years! In a two part series, Mike Younie looks at why interest rates matter for YOU.

But firstly…

What are interest rates?

An interest rate is the rate at which interest is paid by borrows for the use of the money they borrow from lenders. When reading in the press about the current 0.5% rate in place by the Bank of England, this refers to the BoE Basic Rate (the interest rate in which banks charge banks for overnight lending- more on this within a later post!) Interest rates affect everything from your monthly mortgage repayments through to your electricity bills!)

Why are interest rates so low?

When an economy is struggling, an uncomfortable cycle gets set in motion. Pre- financial crash, interest rates hovered between 5% & 7% for many years. This is deemed normal in a healthy economy.

However, as the financial crisis loomed over us, the public became very cautious. In times of financial uncertainty, the safe thing to do is to put your money into a savings account and earn a good rate of interest.

When the public attitude is to save and cut their spending, the amount of money in the economy decreases. Because of this, businesses stop taking in as much money and consequently have to either lay off staff or as we have seen a lot of over the last few years- shut up shop all together. The knock effect of this is increasing un-employment and job insecurity for those still employed. As you don’t know if you will have a job tomorrow, the public tighten their belts even further and the economy slumps into recession!

The economy is in severe need of cash.

This is where interest rates become a very important weapon that authorities can use.

Throughout the financial crash you would heard the term ‘Quantitative Easing’. This is a process in which the government take a few vital steps to easing the pressure on the economy. One element of Quantitative Easing is the cutting of interest rates.

The government need people to stop saving and start spending! They need all the hoarders of cash to hit the shops and start buying!

So how do lower interest rates encourage people and banks to spend and lend?

The idea behind reducing interest rates is that there is now no incentive to keep your cash tucked away as it’s earning you practically no interest. Therefore, it encourages people to go out and seek other forms of investment that have a greater rate of return or to take advantage of the situation and buy goods.

Banks want to invest their cash in safe investments with a guaranteed return on their money. The lowering of interest rates coupled with large scale purchasing of bonds by the government, means that they can no longer invest in ‘sure things’ such as government bonds because the rate of return is poor. Banks hate sitting on money as it does nothing for them, so what are they encouraged to do? Lend to the general public!

Why is this? From a banker considering their return of investment, why invest the money in safe forms of government backed products for a rate of 0.5% when they can lend to the general public/businesses and get a much higher rate of return. Sure- it is more risky lending to the public as the chance of default is higher but they can reflect this additional risk in the interest rate they charge.

If banks are now lending to the public it allows them to start/grow businesses or use the money to go out and spend meaning the economy is getting the much needed cash it desires. Think of the economy as a well- oiled machine, the cogs are people and businesses, the oil is the money. Without it, everything grinds to a halt.

More public spending means more customers for businesses, more jobs for the unemployed, and a much healthier outlook for everyone.

Check back for the second part in our series, explaining why interest rates matter for YOU.

 

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