Being charged interest is part and parcel of borrowing money from a bank.
You’ll be charged interest whenever you take out a loan or a mortgage.
So it pays to get to grips with how interest rates work in the UK and when your mortgage will be impacted.
It’ll help you understand the cost of borrowing money, as well as what to think about when you’re taking out a loan or remortgaging your house.
Let’s take a look at how interest rates work, why they change and when you’ll be affected.
What is the Bank Rate?
The first part of understanding interest rates is to know the difference between the Bank Rate and the interest rates we get charged as consumers.
The Bank Rate is the key interest rate in the UK, set by the Bank of England. It’s the rate commercial banks pay to borrow money from the Bank of England.
The Bank Rate is currently 4%, which is the highest level since 2008.
It was recently increased in February 2023, the tenth rise since March 2020.
The Bank Rate influences all the other interest rates in the UK, including those you have for a mortgage or a loan.
This is because banks pass the cost onto us through interest rates.
What is an interest rate?
The interest rate is the cost you pay each year to borrow money, expressed as a percentage.
You get an interest rate for a mortgage, as well as other kinds of loans.
The higher the percentage, the more you have to pay back.
Lenders will look at the Bank Rate and set their interest rates for different products from there.
So, broadly speaking, if the Bank Rate is high you’ll pay more to borrow money for a mortgage (or any other loan).
You’ll also usually earn more interest on any money you have in a savings account.
Why do interest rates go up and down?
The Bank of England’s Monetary Policy Committee (MPC) will change its key Bank Rate when it wants to encourage or discourage people from spending money.
The MPC will look at the Consumer Price Index (CPI), which measures the cost of different goods and services in the UK. It helps them to understand if inflation is going up or down.
If they find that inflation is going up too quickly, they will increase the Bank Rate to get people to save rather than spend.
Or if they find that inflation is going down or has stagnated for a long period, they will want to get people spending to boost the economy. So they will decrease the Bank Rate.
This has a knock-on effect for the costs we are charged to borrow money.
How does a higher Bank Rate reduce inflation?
A high Bank Rate tends to discourage businesses and people from borrowing money.
It pushes interest rates up, so people avoid borrowing money from banks because they’ll have to pay more back.
And we all spend less on goods and services in general, which reduces demand.
With lower demand, prices do not rise as quickly and so inflation slows down.
The government’s target for inflation is 2%.
The rate of inflation has come down from a peak of 11.1% in October 2022 and is currently at 10.1%, so it's on the right trajectory but still well above the target.
The Bank Rate has been set at a high 4% to try to bring this down.
It is likely to rise to 4.5% in the middle of this year and then fall back to just over 3.25% in three years' time.
How high can interest rates go?
You might have heard of interest rate horror stories from the late 1970s or 1992. In 1979, the Bank Rate was 17% compared to 4% today.
The situation was very different back then, as interest rates were set by the government. As a result, they were more volatile.
Today, the MPC can usually only change the Bank Rate up to 8 times a year.
Since the global financial crisis of 2008, UK interest rates have been at historically low levels. In 2021, they were commonly at 0.1%.
It’s unlikely that we’ll see the Bank Rate – and interest rates – go as high as we did 45 years ago.
But there are predictions that the Bank Rate will rise again this year when the MPC holds its next review. The next one is scheduled this month.
How do interest rates affect my mortgage?
A small change in your mortgage interest rate can make a big difference to the overall cost of the loan.
Imagine you have a £150,000 mortgage that you want to pay off over 30 years.
If the interest rate on the mortgage was 2%, your monthly repayment would be £555. That takes the total cost of the loan to £199,637, including the £150,000 and interest.
If the interest rate on the mortgage was 4%, you’d pay £716 per month. The total cost of the loan would increase to £257,678.
But it’s unlikely you’ll pay the same interest rate for the whole 30 years. Most mortgages are fixed for two or five years, at which point you can hopefully remortgage to a lower rate.
That’s where different types of mortgages come in.
Our mortgage calculator can help you see how different mortgage rates might impact your monthly repayments.
What do Bank Rate changes mean for my mortgage?
Not all borrowers and savers will immediately be impacted by a change to the Bank Rate.
It all depends on what type of mortgage you have.
You can choose to fix a certain interest rate for a period of time, or go with a mortgage where the interest rate changes when the Bank Rate changes.
Let’s take a look at the different types and how they’re affected by changing interest rates.
If you have a fixed rate mortgage
If you have a fixed rate mortgage, the interest you pay will remain the same for the term of your deal.
If you're on a five-year fixed rate loan, for example, your repayment rates are locked in for five years.
That means you will not be impacted immediately by a change in interest rates.
But it might mean you’ll face a more expensive rate when your fixed term ends.
When your fix ends, you’ll usually be moved across to your lender’s standard variable rate (SVR) which can change in line with the Bank Rate.
Look at remortgaging deals before the end of your fixed term. You might be able to find a better deal on a different type of mortgage.
If you have a standard variable mortgage
If you’re on your lender’s standard variable rate (SVR), then a Bank Rate increase is likely to bump your costs up.
Your lender might not increase its SVR by the full amount when the Bank Rate changes. But it’s still likely that your payments will increase.
If you have a tracker mortgage
If you’re on a tracker mortgage, it’s likely you’ll see an immediate change in your monthly payments when the Bank Rate changes.
The interest rate you pay tends to move in line with any Bank Rate changes.
So, as the Bank Rate could change up to 8 times a year (although this is usually unlikely), your rate can go up or down multiple times a year.
If it goes up, you might have the option of remortgaging to change to another tracker or a fixed mortgage with your lender.
What do interest rate changes mean for my savings?
A higher Bank Rate is good news for savers.
Banks will reward you for saving money and increase the interest you can earn on your savings account.
However, interest rates on savings accounts are not keeping up with rising prices. This means the value of cash savings is falling in real terms.
What should I do if I’m struggling to make my mortgage repayments?
If you find yourself struggling to pay your mortgage, contact your lender as soon as possible.
Contact them before you miss a payment if you can. And work out how much you can afford to pay, so you can chat to them with a figure in mind.
Tell them if a change of circumstances has affected your ability to pay, like the loss of a job, illness or a death in the family.
Many lenders have specialist support teams who can explain what options they have. They will work with you to help you find a solution.