Interest rates explained: how a rate cut can affect you

Interest rates are now at their lowest since the Bank of England first opened its doors.

Rates were cut earlier this month to 0.25%, and are expected by some to be heading even lower. But what does this really mean for our economy and what does it mean for you as a British citizen?

The Bank of England (BoE) is the main player in this game and its Monetary Policy Committee (MPC), which sets the Bank Rate, voted for the reduction. The BoE is in charge of keeping the economy afloat so it will influence the economy by lowering or raising the interest rate in an attempt to do so.

It cuts interest rates for a number of reasons, making it cheaper for both the public and businesses to borrow.

It raises interest rates to restrain businesses if the companies/people are borrowing too much. Whenever the interest rate is raised or cut, the pound is impacted and this affects everyone who uses the currency – for example for mortgages, savings, pensions, holidaying etc.

As is probably evident from the information above, the current interest rate cut of 0.25% will affect you. How you say? Well…

Savings

Put simply, a bank rate cut is bad news for you if you’re saving money. The average interest rate on an easy access savings account is 0.65%. But, if that average mirrors the change in the bank rate, this will drop to 0.4%.  So, if you had a £10,000 savings pot before the interest cut, your account would gain £65 of gross interest a year.

After the cut, it will now gain £25 less per year, giving you a gross interest of just £40 a year. Yep, you’ll be £25 worse off.

Banks are allowed to change their rates pretty much as they wish – and they do.

However, banks often do not mirror the interest rates set by the BoE. They are allowed to change their rates pretty much as they wish, as many do, resulting in a lot of banks not waiting for the bank rates to change before they make cuts.

Rachel Springall from moneyfacts.co.uk says ‘there have been a staggering 1,128 cuts to savings deals so far this year compared with just 127 rises.’

Not only are banks cutting interest from accounts, they are also withdrawing deals completely from the market.

This is what happens when you actually have to pay banks to hold your money.

These bank rate cuts will further put a dampener on savers’ accounts, with many seeing their rates heading towards 0% interest and their savings income fall to pitifully low levels.

The Royal Bank of Scotland recently wrote to its business customers to warn them that it might charge negative interest rates if the Bank Rate was below zero. It is unlikely that the 0.25% cut will result in charges for savers but it’s something they may need to be wary of in the future, experts have said. This is what happens when you actually have to pay banks to hold your money.

Mortgages

Depending on the type of mortgage that you have, you may actually be better off from a rate cut. It could mean that your monthly mortgage repayment is reduced. Here are the typical mortgages owned in the UK and how they will be affected.

Santander was the first bank to announce that it would pass the cut on in full. Time will tell whether others will follow suit.

If you own a bank rate tracker mortgage (a home loan that fluctuates with the tide of the BoE rate changes), like one in five mortgage holders do, then you will see an immediate benefit to your mortgage repayment.

Some 29% of mortgage holders have home loans that are on a standard variable rate (SVR). This means that whether or not they benefit from the BoE’s rate cut relies on decisions made by the mortgage lender – some may decide to pursue the cut in full, others may decide to only pursue a partial cut.

Santander was the first bank to announce that it would pass the cut on in full. Time will tell whether others will follow suit.

About 46% of mortgage holders are on fixed rate mortgages. They will see no change at all to their repayments. More and more people have been signing up to longer term fixed rate deals which can last for up to 10 years.

For them, this interest rate change is fairly irrelevant. However, for those coming up to the end of their agreement, it could be a big deal.

Those wanting to take out a new mortgage may find that they pay less if and when they sign up.

Pensions

The rate cut will also affect pensions. It will add extra pressure on the deficits facing defined benefit pension schemes (a scheme where the amount you’re paid is based on how many years you’ve worked for your employer and the salary that you’ve earned), putting increased pressure on businesses to plug that gap or reduce the availability of such pensions.

Those who are buying an annuity (a retirement income for life) from their defined contribution pension pot may also now get a worse deal.

The upside to this pension problem here is that, on this rate reduction, the 0.25% cut will have no effect on the state pension. The bank’s rate decision means that share prices have been driven up so those still paying into a private pension – and, indeed, investors in general – will see a boost in the value of such investments. At least that’s some good news!

Holiday Money

The value of the pound will drop significantly and so when exchanging your pound sterling for foreign a currency, you will get a lot less than before.

*More information on the Term Funding Scheme can be found here.