This article was last updated on 07/11/2024
Interest rates can affect the amount you’d earn on your savings and the amount you’d need to repay on your debts. A change in interest rates can create a ripple effect throughout a country’s economy.
When interest rates rise, the cost of loans (such as mortgages) increase meaning you’d pay more in interest over time. On the flip side, higher interest rates can benefit savers, as they earn more on the money saved in any savings accounts.
What’s an interest rate?
Interest rates are typically calculated annually, but can also be paid monthly or quarterly. For example, if you have £1,000 in a savings account with a fixed 2% annual interest rate, you’ll earn £20 in the first year. If you leave that money untouched, in the second year, you’ll earn £20.40, and in the third year, £20.81.
This method of earning interest on both your initial savings and any interest already earned is called compound interest. It can make both savings and debt grow like a snowball rolling down a hill - as it rolls, it picks up more snow and grows larger.
What’s the relationship between inflation and interest rates?
In moderation, inflation and interest rates are key to growing the prosperity of a country. The difficulty occurs when one experiences instability and becomes too high or low. The danger of leaving inflation and interest rates untreated is a recession.
High inflation is an economic ‘fever’ where symptoms include:
- a loss of appetite to spend money (due to rising prices); and
- a weakness in currencies.
Central banks (such as the Bank of England) try to provide the financial stability needed for a healthy, growing economy. So when inflation is running high, central banks may prescribe raising interest rates to lower the levels of inflation.
This antidote of raised interest rates doesn’t correct inflation overnight and may have side effects of its own, such as:
- it being more costly for you to borrow money for loans or mortgages; and
- more attractive interest rates for cash savers.
What causes interest rates to rise?
Here are two common reasons why a rise in interest rates happens.
1. Increased demand for credit
When more people and businesses want to borrow money, the demand for loans increases. Lenders can raise interest rates because there are more borrowers competing for the same amount of money. For example, during ‘economic booms’ businesses often seek loans to grow, which can push interest rates higher.
2. Inflationary pressures
Central banks often raise interest rates to combat rising inflation. When prices go up, the purchasing power of money decreases, so lenders want higher interest rates to compensate for the reduced value of future repayments. This helps keep inflation in check and can slow down an economy that is growing too quickly.
How are interest rates set?
The Bank of England reduced the Bank Rate to 4.75% in November 2024. This decision reflects the Bank of England’s ongoing efforts to manage inflation, which has been gradually stabilising since it peaked at over 11% in October 2022.
The government has tasked the Bank of England to keep inflation at around 2% a year. The Bank of England provides loans to high street banks and other financial institutions at a certain interest rate, known as the Bank Rate.
What is the impact of the Bank Rate?
When the Bank Rate changes, it may impact how much financial institutions:
- charge for loans; and
- pay on savings accounts.
For example, if the Bank Rate is 3% a bank may lend money to customers at an interest rate of 4% and pay customers an interest rate of 2% on their savings. The difference (called a margin) is one of many ways that banks earn money.
What to do when interest rates rise?
When interest rates go up, savers and borrowers are affected in different ways. Here’s how to handle these changes easily.
Savers
When interest rates rise, banks often increase the rates on products like cash savings accounts. This means you could earn more interest on your easy-access or emergency fund savings. To ensure you’re getting the best deal, consider using a comparison website to check current rates.
Consider saving more
With higher interest rates, it’s also a great opportunity to get better returns on your savings. If your bank isn’t offering competitive rates, it might be a good time to switch so you can take advantage of the increased interest earnings.
Borrowers
If you have existing loans, such as a mortgage or student loan, rising interest rates could lead to higher monthly payments, especially if you have a variable rate loan. Those with fixed-rate loans will be shielded from immediate increases, but variable rate borrowers may see their payments rise quickly.
Pay off debt faster
In light of rising rates, it may be wise to pay off your debts as quickly as possible. This can help you avoid accumulating more interest over time, making your overall repayment more manageable.
Shop around for better deals
As interest rates rise, the market ‘reshuffles’ as older deals are replaced by new ones that may be more favourable. Take the time to shop around for better deals on loans or refinancing options that could save you money in the long run.
How do interest rates affect pensions?
Pensions usually invest your money in the stock market and other assets, which can grow faster than the interest earned in a bank account. While interest rates don’t directly impact the stock market, they can have indirect effects.
When interest rates are high, people may choose to save more instead of spending, leading to lower sales for companies. This can make companies less attractive to investors, which may reduce their share prices.
On the other side, if a company has a lot of debt then higher interest rates will increase their debt payments. This can negatively affect the company’s share value and, in turn, the investment returns on your pension savings.
Before retirement
Typically when interest rates are high, it’s bad news for your investments in the stock market - as they often move in the opposite direction. Higher interest rates can lead to lower share prices because borrowing costs rise and consumers may spend less.
However, the stock market is affected by various factors, not just interest rates. For example, strong company earnings, investor confidence and economic growth are likely to move share prices - even in a rising interest rate environment.
After retirement
After retirement, interest rates can impact pensions and retirees. Pension funds usually invest in assets like bonds, shares and real estate. When interest rates rise, newly issued bonds provide better returns, which can help pension funds grow.
On the other side, low interest rates can reduce returns. In a low-interest environment, retirees may have to withdraw more from their savings to maintain their standard of living, as their investments may not generate enough income.
Summary
Now’s a great time to start looking at your pension contributions and ensure you’re on track to retire with enough money. To see how much your pension could be worth at retirement and how long it could last you, try our Pension Calculator.
Once you turn 50, you’re able to book an appointment with Pension Wise, a government service set up to help people understand what their options are when they retire. The great thing about Pension Wise is the appointments are free and completely impartial. You can read Personal Finance Journalist Faith Archer’s blog, What happens in a Pension Wise appointment, to understand the step-by-step process.
Have a question? Get in touch!
Do you want to know more about your pension plan with PensionBee? You can check out our Plans page to learn how your money is invested in different assets and locations, or log in to your BeeHive to see your specific plan. You can always send comments and questions to our team via engagement@pensionbee.com.
Risk warning
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
