MoneyGuide

When will interest rates go up, and what will the consequences be?

Updated: Friday 16 March, 2012

By Martin Fagan

Historically low interest rates mean lower mortgage repayments, but poor savings returns. We look at what will happen when rates start to rise again.

The historically low Bank of England base rate has helped define consumer financial services since March 2009, when the base rate was lowered to 0.5% and has stayed there ever since. Anyone with a variable rate mortgage will have benefited, but for people who rely on the income from savings, such low interest rates have been a disaster.

So, why are interest rates so low and when can we expect them to rise?

Rate cut history

The Bank of England cut rates aggressively to stimulate the economy and avoid a recession.

It started to cut interest rates in October 2008, when it pushed them down from 5% to 4.5%. Over the following six months it pursued a policy of cutting aggressively until rates reached 0.5% in March 2009.

Ultimately the UK was unable to avoid slipping into recession.

The rate has now been 0.5% for three years and the Bank has also attempted to kick-start the UK economy using a policy of quantitative easing, creating “electronic” money that it uses to buy back government bonds (gilts) from financial institutions in the hope the financial institutions will use the money to lend to creditworthy individuals and companies.

When will rates go up?

The base rate is used by the Bank of England to control inflation. In recent months, inflation has risen sharply - much higher than the government’s stipulated target rate of 2%. Nevertheless, despite inflation hovering at 4.5% for most of 2011, the Bank of England did not respond (as many predicted) by increasing the base rate. In the first months of 2012, the inflation rate has slipped back to 3.5% taking the pressure off the Bank to raise the base rate. However, several factors will determine when and how sharply rates will go up in the future, including the following:

• The consumer prices index (CPI) and retail prices index (RPI) both give a measure of inflation on a monthly basis. However, neither figure is turning out to be as low as expected on a monthly basis. But, at least for the moment, the Bank is holding fire on raising rates.
• Quantitative easing - the Bank of England’s programme of quantitative easing swaps high street banks’ assets, such as bonds, for cash, so that the banks would have the readies to lend to creditworthy individuals and businesses.

But so far the banks have been sitting on this cash, rather than lending it, so the effects of quantitative easing in the real economy hasn’t been as dramatic as the Bank would have liked. When this money does begin to flow into the real economy, this could result in a rise in inflation and thus the base rate may be increased.

At one extreme, some experts believe that we are in for many years of low inflation and low interest rates - perhaps as far out as 2013 and beyond.

At the other end of the scale, another set of experts believe quantitative easing coupled with massive public debt will mean that interest rates will have to rise sharply sooner rather than later.

What are consequences of higher interest rates?

Mortgages: If the base rate rises, anyone on a variable rate mortgage, such as a tracker or their lenders standard variable rate (SVR), will find their monthly repayments will go up.

If you want to see what effect rising interest rates would have on your mortgage repayments, use our mortgage calculator.

For mortgage holders who feel that rising rates are their biggest concern, one option is to switch to a fixed-rate mortgage - which will give them certainty about their mortgage payments for a given term.

However, banks are putting a high premium on fixed-rate mortgages - they are historically expensive. So borrowers will have to think this decision through very carefully, perhaps with the help of an independent financial adviser.

It is possible that when interest rates start to rise, it could push more people in arrears in their mortgages if they find they are unable to meet their monthly mortgage repayments.

Unemployment, one of the major reasons people fall into arrears, is at its highest level in 17 years, and businesses continue to shed workers. But confounding expectations and historical precedence, The Council of Mortgage Lenders say that the number of repossessions in 2011 (36,200) was the lowest annual total since 2007.

Savings: Savings rates initially fell along with the Bank of England base rate. And while mortgage holders have been blessed with falling mortgage rates lowering their monthly payments, savers have been having a torrid time of it.

A survey of the savings market by consumer rights group Which?, conducted in March 2012, found that 41% of the 1,800 savings accounts and cash ISAs available to UK savers were paying a paltry 0.5% a year or less. One in five savings accounts was paying 0.1% or less.

Which? says this can add up to just £1 a year for every £1,000 in your account, or a collective £13 billion of interest lost each year by savers failing to switch savings accounts to ones paying higher rates. Current high rates of inflation also mean that these purchasing power on the money held in these accounts may be worth less each day.

However, for the most part, savings rates - particularly for ISAs - are still low. Therefore anyone with savings tempted by the potentially higher returns - and higher risks - of the stock market should discuss their full financial situation with an independent adviser, to make the best of the returns available without taking on unnecessary risk.