The Bank of England’s Monetary Policy Committee (MPC) is responsible for setting the Bank Rate.
The goal is to keep the supply and demand of goods and services roughly equal, resulting in a rate of inflation of 2%. This keeps the price of goods relatively stable whilst allowing economic growth.
Consumer Price Index (CPI) represents prices paid by consumers. Price data of goods is recorded each month and the CPI is then used to calculate inflation. The higher the price of goods, the higher the CPI. The faster the CPI increases, the higher the rate of inflation.
When demand exceeds supply, the costs of goods increase, resulting in a rate of inflation above Bank of England’s target of 2%. When supply exceeds demand, the costs of goods decrease, resulting in a rate of inflation below the Bank of England’s target of 2%.
Where are we now?
When the global financial crisis struck, the Bank of England dropped its Bank Rate to 0.5% in March 2009. In August 2016 the Bank Rate was reduced further to 0.25% and has been at 0.25% ever since. The reason for this was to encourage lending by the banks so people have more to spend and this would in turn result in economic growth.
Inflation rate has now risen to 3% which is the highest since 2012 and above the Bank of England’s target of 2%. This is the reason a possible rise in the Bank Rate in November 2017 has been headline news in recent weeks.
What does a higher Bank Rate mean?
Increased costs of borrowing:
Interest rates on consumer debts will increase, resulting in higher monthly payments on your mortgage, loans and credit cards. An increase in monthly payments means less disposable income.
Reduction in borrowing on a mortgage:
The maximum mortgage you can borrow against your residential property will decrease. This is because lenders use a stress rate to ensure you can afford the mortgage if the interest rates were to increase. When the Bank Rate increases the stress rate that lenders use also increase, resulting in a lower loan.
Higher return on your savings:
The average interest rate on an easy access savings account is only 0.42%, this is lower than the current inflation rate of 3%. In real terms the value of your savings is reducing as the buying power of your cash is eroded by rising inflation, this means there is lower incentive to save. So if the interest rate of savings increases, it will increase the incentive to save.
Increased value of the pound:
As interest rates increase, investors are more likely to save in UK banks rather than other countries. A stronger pound increases imports whilst reducing exports.
Increased interest payments on government debt:
Even the government’s interest payments will be higher as a result of the increased Bank Rate. This could possibly mean higher taxes to support the higher interest payments.
So what should you do?
In the short term, the changes to interest rates are likely to be small, but several rate rises over the years could have a significant impact on your finances.
Re-assess our finances, work out how much you have left after essential outgoings expenses (taking into account any increased monthly payments on debt). If you find you will be tight on money, review where you can cut back your outgoings.
Switch your mortgage to a better rate. You could choose to re-mortgage and lock in your monthly payments at the current lower interest rates for a fixed period (such as five years). Make sure you do your calculations, this could be more costly as fixed rate mortgage products tend to have higher arrangement fees. You may think it is worth the extra costs to know that your mortgage payment for the next five years is fixed, allowing you to plan your finances better.
Shop around for savings accounts or high interest current accounts, take advantage of any interest rate increases coming up.