Raising and lowering interest rates is a blunt instrument used by central banks to control economies.
An increase in the “base” rate increases the cost of borrowing, making both loans and investments more expensive. The idea is to put the brakes on the economy and prevent rising costs of goods and services – known as inflation.
Lowering rates is an attempt to have the opposite effect – stimulating growth by making borrowing cheaper, and in turn, encouraging 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 increase since December last year, with analysts believing that the move could lead to further hikes. It also indicated that it believes the economy is already in recession.
As a sign of trouble in the economy, that means rates are now at their highest level since 2008, when the banking collapse forced monetary policymakers to reduce borrowing costs.
Here’s what it means for households and why any gains would be modest.
Why are rates rising so much?
The Bank of England is tasked with keeping inflation under control, with a target of 2% per year.
But in recent months, inflation has started to run away. It rose to 9.9% in August and is still expected to strike a 40-year high “below 11%” despite government action to freeze energy bills, according to a new forecast from the bank.
Members of the bank’s Monetary Policy Committee (MPC) said on Thursday that inflation is likely to remain high following energy support for households, as it will boost the spending power of many.
But by increasing interest rates, banks make it more expensive to borrow money, so people are likely to spend less.
If people – and businesses – are forced to spend less, demand will drop, and prices will fall, or at least growth will soften.
How will the hike in interest rates affect people?
The most obvious effect is that it will become more expensive for people to pay off their mortgages.
Those taking a new loan will soon be quoted a higher interest rate as a result of the change of bank.
And those whose mortgages are being renegotiated may face bigger bills than before.
Trade association UK Finance said the rate hike would mean mortgage borrowers, whose deals directly track the base rate, would increase their payments by an average of around £49 a month, adding up to around £600 a year.
The data also showed that a borrower sitting at their lender’s standard variable rate (SVR) would typically see a monthly increase of under £31, up to around £370 per year.
About 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 hike.
But, if they have been securely locked into their home loan for some time, they may eventually get hit with a re-mortgage. A year ago, it was possible to get an interest rate of less than 1% for two or five years. Now even the best deals are in the region of between 4% and 4.5%.
People with other types of debt will also feel the pressure.
Anyone with an existing fixed-rate personal loan, credit card or car loan will be unaffected as their loan terms have already been agreed upon.
But new borrowers shopping for credit may find the cost of the loan higher. Borrowing costs on credit cards are already rising, with the average credit card purchase APR (which includes card fees) rising to an “all-time high” of 29.6% APR.
Why is the cost of living rising so much?
Inflation is a measure of how much the average household item price is changing, with Ukraine warring a serious cost-of-life crisis where wages are failing to keep 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 contribute about 40% of the inflation the bank is expecting in October.
Nevertheless, the bank highlighted that the decision by the new government of Liz Truss to freeze energy bills for the average household at £2,500 means that inflation will not be as high as previously expected.
Who benefits from the hike in interest rates?
The increase in interest rates will be of little benefit to the savers as the banks in which they keep their money can increase the amount of interest they get on deposits.
According to Moneyfacts.co.uk, the average rates offered on some savings accounts have reached their highest level in nearly a decade.
However, many savings accounts have yet to raise their rates to the level of interest rate hikes.
Alice Hahn, personal finance analyst at BestInvest, said: “While banks and building societies are quick to implement higher rates for loans, they may be a little slow to deliver the good news to savers.”
The effect of increased interest accruing to savers will also be more than offset by inflation, which does more than reduce savings.