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Raising and lowering interest rates is a blunt instrument used by central banks to manage economies.
Raising the “base” rate increases borrowing costs, making both credit and investment more expensive. The idea is to put the brakes on the economy and curb the rising cost of goods and services, known as inflation.
Lowering interest rates is an attempt to have the opposite effect – to stimulate growth by making borrowing cheaper and in turn encourage investment.
On Thursday, the Bank of England – the UK’s central bank – said it would raise interest rates by 0.5 percentage points to 2.25%.
This is the seventh consecutive rise since December last year, and analysts are confident that more increases could follow the move. He also expressed his belief that the economy is already in recession.
In a sign of trouble in the economy, that means interest rates are at their highest level since 2008, when the banking collapse forced monetary policymakers to cut borrowing costs.
Here’s what that means for households and why any gains will be modest.
Why are interest rates so high?
The Bank of England is tasked with keeping inflation under control by targeting 2% per year.
But inflation has started to run away in recent months. It hit 9.9% in August and is still expected to hit a new 40-year high of “just below 11%”, according to the Bank’s new forecast, despite government moves to freeze energy bills.
Members of the Bank’s Monetary Policy Committee (MPC) said on Thursday that inflation is likely to remain high after the energy support for households, as it will boost the spending power of many people.
But by raising interest rates, the Bank makes borrowing more expensive, so people will spend less.
If people and businesses are forced to spend less, demand will decrease, prices will fall, or at least increases will moderate.
How will interest rate hikes affect people?
The most obvious effect is that it will become more expensive for people to pay their mortgages.
As a result of the bank’s change, new borrowers will soon be offered a higher interest rate.
Those whose mortgages are being renegotiated will likely face larger bills than in the past.
Trade association UK Finance said the rate hike would see mortgage borrowers whose deals directly track base rate pay an average rise of around £49 a month, rising to around £600 a year.
The figures also showed that a borrower sitting on the lender’s standard variable rate (SVR) would typically see an increase of just under £31 a month, adding up to around £370 a year.
Almost four fifths (78%) of outstanding residential mortgages are fixed rate, meaning these borrowers will not see the immediate impact of the Bank’s base rate rise.
However, if they have been securely locked into a home loan for a while, they may be in for a shock when they eventually remortgage. A year ago it was possible to get an interest rate of less than 1% for two or even five years. Now even the best deals are between 4% and 4.5%.
Those with other types of debt will also feel distressed.
Anyone with an existing fixed rate personal loan, credit card or car loan will not be affected as the terms of the loan have already been agreed.
But new borrowers shopping for credit may find the cost of debt higher. Credit card borrowing costs are on the rise, with the average credit card purchase (including card fees) rising to an “all-time high” of 29.6% per year.
Why is the cost of living so high?
Inflation is a measure of how much the price of things the average household buys has changed, with the Ukraine war exacerbating a crippling cost-of-living crisis where wages haven’t kept pace.
Inflation is likely to peak in October, largely due to the amount people pay for the energy they use to run their homes. Energy prices will make up 40% of inflation expected by the Bank in October.
However, the Bank stressed that Liz Truss’ new government’s decision to freeze energy bills at £2,500 for the average household means inflation will not rise as much as previously expected.
Who benefits from the interest rate hike?
Depositors will benefit at least slightly from the interest rate hike, as the banks they keep their money with will increase the interest they pay on deposits.
According to Moneyfacts.co.uk, average interest rates offered on some savings accounts have reached their highest level in almost a decade.
However, many savings accounts have not seen interest rates rise to the level of interest rate hikes.
Alice Haine, personal finance analyst at Bestinvest, said: “While banks and building societies have been quick to apply higher rates to loans, they can be a bit slow to deliver the good news to savers.”
The effect of increased interest earned by savers will also be offset by inflation, which will more than reduce savings.