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What Are Interest Rates Anyway – And How Do They Work?

in Banking, Blog, Mortgages

The Interest Rate on a Loan

Most people are familiar with how basic interest rates on loans are calculated. Anyone who knows how to figure out a percent discount can easily determine how much interest will be paid on a simple loan. For a loan with 10% interest paid on a balance of £100, ‘£100 x 0.10 = £10.’

Things get a little more complicated when loans are paid in instalments over many years, as a mortgage is. Interest on a loan is usually expressed as an annual rate, but the payments are more frequent. Typically, mortgages have an annual interest rate that is compounded monthly. That means that the borrower pays 1/12 of the annual rate on the current balance each month.

The Bank of England and Base Rates

In the U.K., the Bank of England sets the base interest rates. The Bank of England is a type of public, government controlled institution known as a ‘central bank.’ The base rates set by the Bank of England are a tool of government monetary policy. The British government may use the interest base rates to stimulate the economy or to control inflation.

The Bank of England controls short-term rates of interest by lending money or borrowing money from commercial banks until the rate settles at their target value. They’re able to do this because they have the authority to issue currency. The actual rates of interest paid on long term loans like mortgages are always higher than the base rates, because the commercial lenders incorporate risk calculations and other factors in determining real-world rates.

What Happens When Rates Go Down?

When interest rates go down, it becomes cheaper to borrow money, and saving or investing money becomes less profitable. This is convenient for consumers and it can help to increase capital investment. Increased capital investment will stimulate the economy, especially if there’s a lot of deferred investment out there. However, low rates of interest make it difficult for banks and investors to profit from financial transactions.

The dodgy loans that were made by many banks in the early naughties – the loans that helped bring about the financial crisis and the current recession – were partly in reaction to a combination of very low rates of interest and inadequate risk assessment. People with few resources were encouraged to take on debt that they couldn’t afford to maintain with even a small increase in rates or change in circumstances.

What Happens When Rates Go Up?

When interest rates increase, it becomes more expensive to borrow money, but savings and investments tend to be more lucrative. Higher rates of interest help ordinary people to save a decent amount of money for retirement, and to get more out of the money they put aside for their children’s educations and for other future expenses.

However, an increase in interest rates can have a devastating effect on the affordability of long term, variable rate loans like most British mortgages. A five percent increase in the interest rate can increase the monthly payments on a 20-year loan by 50%. For example, if the current payment is £1000, then it could increase to £1500. That’s because the total interest over such a long period of time adds up, and most of the money paid into a mortgage is interest, not principal.

That’s why it’s so important to take the future affordability of a variable interest loan into consideration when deciding how much to spend on a property and what sort of mortgage loan to use.