The annual inflation rate for the UK is set once a year. It is calculated by comparing the price of everyday goods and services from the previous year.
Rising inflation affects all parts of our lives, from your weekly shopping to your morning commute into work. However, one of the areas it influences the most is interest rates.
Whether you have savings in a bank account or are taking out a loan to boost your finances, inflation will have an effect. Read on to find out what happens when inflation rises and how it affects the interest rates you are offered.
What causes inflation?
Inflation is caused by an increase in the costs for everyday goods and services. This means if the UK’s annual inflation rate rises by 2%, on average, the price of your shopping will be 2% higher than it was last year.
This rate is calculated by the Office for National Statistics (ONS) by looking at how certain goods and services, such as furniture and household items, have influenced the overall Consumer Prices Index.
Sometimes, you can face higher costs than the UK’s inflation rate on a particular service, such as train tickets, if there’s an increase in demand.
About interest rates
Interest rates are charged as a percentage and can be applied in one of two ways:
- Money owed – When you take out a loan, the interest rate is the amount you would need to pay back on top of the money borrowed.
- Money saved – If you have a bank account, your interest rate is a percentage of the money saved there which you will earn back from the bank.
When taking out a loan, there isn’t a set interest rate you’ll be offered. This is because there are a number of factors that can affect your rate, such as your credit score and the amount you wish to borrow.
However, most lenders’ rates will be influenced by the Bank of England base rate. This is set eight times a year depending on inflation and the economy, but it can stay the same for years.
How interest rates affect borrowing
If the bank’s base rate changes, it could affect loans you take out in the future.
For instance, if the base rate decreases, you could be offered a lower interest percentage on a loan, and in turn, save money on your monthly repayments. This could make it easier to take out a higher loan for those big ticket items, such as a home or car.
However, if the base rate increases, the cost of borrowing will also go up, meaning you will pay more money overall to take out a loan. This can cause your monthly repayments to increase, making it more difficult for you to afford to borrow larger sums of money.
It’s worth pointing out, while you may get a better deal on your loan if interest rates decrease, you’ll also earn less interest on your overall savings in a bank account.
How does inflation affect interest rates?
The relationship between inflation and interest rates is interchanging, meaning when one rises, the other will usually fall.
The Bank of England base rate is set up to purposely help keep the UK’s inflation target of 2%.
When interest rates decrease, there’s an increase in borrowing. This means people have more money to spend on the economy, subsequently causing inflation to rise.
Additionally, if the economy is growing at a rapid rate, the bank may increase their base rates to slow spending and keep inflation down.
If the Bank of England predicts this 2% inflation target can be met without interference, the bank’s interest rate will remain unchanged.
How interest rates affect your loan
If you already have a loan, an increase in interest rates shouldn’t affect your monthly repayments if your loan is a fixed rate. This is because the total amount you will pay back, known as the Annual Percentage Rate (APR), is calculated before you take out a loan.
Part of your loan’s APR is your interest, which is offered at a fixed rate. This means throughout your loan term, the percentage of interest you pay back will stay the same. This can be both positive; if the bank rate increases, your repayments won’t go up, and negative; if the rate lowers, you won’t be able to save on your monthly payments.
The only time you may be affected by a rise in interest rates is if your interest rate is variable, which could be the case on your mortgage. When your fixed interest rate on your mortgage comes to an end, you’ll automatically switch to a Standard Variable Rate. This default rate can then fluctuate depending on inflation and the bank’s base rates.
When taking out a loan, check your terms to see if you could be affected by inflation through variable interest rates. With Norton Finance, we search the market to find you a suitable repayment plan for your circumstances. Explore our range of loan products today.