Interesting. Honestly, it is!
Hands up who’s an interest rate geek…oh, that’ll be just me then. Okay, before you run to the hills, I’m going to give it my best shot to raise your interest level in the subject...see what I did there?
Firstly, let’s address the elephant in the room – interest rates can be confusing. Banks don’t set out to deliberately baffle you, it’s just they presume you already know the ins and outs of how interest rates works. To be honest, before I began my career in banking it was all foreign to me, but now that I speak financial lingo fluently, I’m going to break things down for you and give you a better and broader understanding of interest rates.
Let’s start with the basics
For every £100 of your savings, a bank needs to hold around 20% (£20) in reserve. They do this to cover potential customer withdrawals. This £20 is generally referred to as the ‘liquidity reserve’. So what about your remaining £80? Well, they lend it out, to their mortgage customers for example. However, the £20 that’s in reserve usually only earns an interest rate below the rate banks would pay to savers.
The real value of banks to customers is that they help bridge the gap between your saving and borrowing needs. Put simply, most people want to borrow long-term, like 25 years for their mortgage, but save short-term through an easy access account, perfect for a wedding or dream holiday. A bank’s job is to balance these two important options and cater for both requirements.
Whether you borrow money for a mortgage or a credit card, the amount you pay back is dictated by the interest rate, plus any additional fees. Essentially it’s the cost to you for borrowing the money, and it’s typically expressed as an annual percentage rate (APR).
Interest for savers is the rate your bank or building society are willing to pay you for borrowing your money. Here’s a quick example of how it works. Let’s say you have £1,000 in a savings account earning 2% interest annually. That £1,000 will earn you £20 in interest, giving you £1,020 after one year. I know…it’s hardly a life changing amount, but every little helps as they say.
The interest you earn varies depending on the product you choose. It’ll also be affected if the balance of your savings account fluctuates during the period that the interest is being calculated.
What can influence interest rates?
Are you sitting comfortably? There’s a lot to take in during this bit, so deep breath, here we go…
Some banks pay more than others for exactly the same product e.g. savings accounts. In fact, it’s not uncommon to find more than 0.50% between banks, and that can really start to add up.
The Bank of England (BoE) sets the bank rate (or ‘base rate’) for the UK, and the rate’s currently sitting at 0.25%. This is the interest rate that the BoE charges commercial banks for money borrowed overnight, and the rate that banks get for any deposits with the bank overnight. As consumers we don’t pay this rate, but it does have a knock-on effect on the borrowing and lending rates set by high-street banks and building societies.
The base rate can hugely influence the interest rates set by financial institutions, including banks. If it goes up, it’s likely lenders will want to charge more as the cost of their borrowing increases. This works in exactly the same way for savers. If the BoE base rate rises, you’d expect the interest earned from your savings to increase (whoop, whoop).
For you that could mean an increase on the income you receive from your savings, but unfortunately it would also push up the interest you pay on your debts. The most significant impact of this is usually the increase to mortgage repayments.
Where interest rates are concerned, you really do have to consider the bigger picture, and by big, I mean global. Economic conditions are the most important factor for bank interest rates. Whether you earn a lot or a little from your savings really depends on conditions in the world as a whole.
Rates are at their lowest during slow economic times – just look at the last 10 years where base rate peaked at 5.75% in July 2007 then dropped to 0.25% by August of this year. When the markets are unpredictable and volatile, there’s not much demand for money, so you aren’t rewarded for handing over your cash to your bank. Sometimes there isn’t demand for money because consumer confidence is low, so people look to borrow less overall. Trust me, the bank will always be happy to use your money, but when they can’t do much with it, they’ll pay you a lower rate.
Rates can also be affected by how quickly a bank wants to grow, or how much lending the bank is doing. This commercial need is why you’ll notice different banks are competitive at different times. If they’re looking to get deposits in the door, they’ll potentially tempt you with a high rate on savings accounts to attract your money. If, on the other hand, they don’t really need or want the cash to grow, they’ll simply keep their rates low.
Operating models and overheads also have an impact on how the rates are set. Some banks will choose to pass their profit, or saving, onto their customers. Others will keep it for profit, or use it elsewhere within the business. For example, banks or building societies with a branch network up and down the UK will have huge overheads – the cost of staff, rent, upkeep, the list goes on – often means they cannot offer as low rates as online only providers. Obviously at Atom, we’re not one of those banks with branches, we’re digital only, so our overheads are kept to a minimum which is good news for anyone looking to save with us…more on that very shortly :)
The last thing that can influence interest rates is the future rate outlook. If banks or the market in general think that the base rate is going to go up, they may offer a higher rate of interest prior to this.
So there you have it. I’ve tried to make interest rates more interesting. Hopefully at least half of you are still awake, because if you’re in that 50%, you’re in for a treat.