Understanding Interest Rates

Understanding Interest Rates in 2023

Interest rates: a term we often hear, but do we truly understand how they affect our daily lives? From mortgage payments to savings accounts, interest rates play a pivotal role in shaping our financial decisions. To keep up-to-date with the latest Interest Rate predictions, read here.

What are interest rates?

To better understand how likely it is that interest rates will rise or fall, we must first explain what interest rates are. When you borrow money, the interest rate is the fee charged as a percentage of the amount borrowed. But why do such things as interest rates exist? You should remember that the company that borrowed the money loses the opportunity to reinvest it, which is why borrowed money accrues interest. The level of interest rates is set by the central bank or government (usually the Monetary Policy Committee).

The Monetary Policy Committee is responsible for setting the base rate, also known as the bank reference rate, in order to achieve the government’s inflation target. By adjusting the bank reference  rate, the MPC can influence the overall level of interest rates in the economy, thereby impacting borrowing and saving decisions made by consumers and businesses.

How does their increase affect our daily lives? First, it leaves an imprint on borrowers, especially those with mortgages to repay. Higher interest rates result in higher borrowing costs and higher monthly payments for borrowers (of course, this rule also applies to consumer loans, such as car loans). But that doesn't mean raising interest rates can't benefit them. For those with savings, rising interest rates will cause interest rates on their savings accounts to rise (savings account rates may also rise due to rising interest rates, benefiting savers). However, it's important to remember that even the fall in top interest rates may not keep up with inflation, suggesting the real value of cash savings may fall.

Even if interest rates rise, investing is not indifferent. This affects the profitability of debt securities, particularly in the bond market. As interest rates rise, new bonds issued at higher interest rates become more attractive to investors. As a result, older bonds previously issued at lower interest rates may become less attractive. Since the value of previously issued bonds may fall in the secondary market, investors prefer to purchase new bonds with higher yields. By paying attention to your bank's reference rate, you can better understand and prepare for possible interest rate changes.

Factors causing interest rates to fall

Lower interest rates won't happen overnight, and sometimes they seem far off. To understand why this happens, we need to explain what needs to happen to cause interest rates to fall. There are several factors.

When an economy experiences a downturn or recession, central banks may decide to lower interest rates to stimulate economic activity. Such interest rate cuts would encourage borrowing and spending, thereby increasing consumer spending and business investment. Lowering interest rates to improve the supply of credit is a common element of central bank monetary policy.

Another reason is that inflation has fallen sharply. To stimulate price growth and avoid deflation, banks may decide to lower interest rates when inflation falls below the central bank's target level (usually around 2%, but this is by no means a hard and fast rule).

Of course, interest rate forecasts predicting falling interest rates are not limited to local factors. Global factors such as a global economic slowdown, changes in economic policies in other countries, or uncertainty in financial markets also play a role.

Interest Rates and Inflation

When a bank or financial institution lends money, you usually have to pay back more than you borrowed. This is because interest rates make borrowing more expensive and make individuals and companies less willing to invest and borrow.

Simply put, inflation is a general increase in the prices of goods and services, the point at which these goods become more expensive. When inflation rises, money loses value because more financial resources are required to purchase the same thing.

The inflation rate is a primary factor in determining changes in interest rates, as central banks aim to maintain price stability. When the inflation rate rises above the central bank’s target, the bank may decide to raise interest rates in an effort to curb inflation and stabilise prices. Conversely, if the inflation rate falls below the target, the central bank may lower interest rates to stimulate spending and boost economic growth.

As of now, global inflation levels remain high, and the Federal Reserve and the European Central Bank are expected to raise interest rates in the coming months of 2023. In order for interest rate forecasts to predict an interest rate reduction, inflation must fall significantly. It doesn’t have to be the 2% mentioned above, but it must be a single digit.

Wage Growth and Interest Rate Increases

Employment and wage growth also influence interest rate forecasts because they affect consumer spending and overall economic growth. When employment and wages are rising, consumers typically have more disposable income to spend, which can lead to increased demand for goods and services and, in turn, higher prices. Central banks may respond to this by raising interest rates to control inflation and maintain price stability.

Keeping track of employment and rising wages growth trends can provide a clearer picture of the overall health of the economy and its potential impact on interest rates. This knowledge can help you make informed decisions about your financial strategies, such as whether to pursue new investment opportunities or adjust your savings plan to account for potential changes in interest rates.

The Impact of Rising Interest Rates on Mortgage Loans

Mortgage repayments can be significantly affected by changes in interest rates, especially for those with variable-rate mortgages. When interest rates rise, monthly repayments on these mortgages typically increase, putting additional pressure on mortgage customers’ household budgets.

The increase in interest rates is unfortunately bad news for individuals who are not currently borrowers but plan to become ones. Faced with such a situation, they may have a harder time accessing mortgage loans. Furthermore, the limitation of creditworthiness for individuals who do not receive sufficiently high incomes can affect their ability to purchase real estate. In the longer term, this could lead to a slowdown in the real estate market. If loan installments become too high, potential buyers - forced to hold off on buying a house or a large, well-located apartment - may decide against taking out a loan or opt for smaller properties.

Long-term growth in interest rates also has a negative impact on the economy as it affects consumption and investments, and in the broader perspective, overall economic activity. If many people have higher monthly repayments, their consumer capacity will decrease over a longer period. Specifically, until interest rate conditions improve - which unfortunately usually does not happen quickly.

This article aimed to present perspectives on future changes in interest rates, explaining that their impact affects both borrowers, investors, and the economy in general. It's worth remembering that the interest rates rise leads to higher loan costs and can influence a slowdown in the real estate market and economic activity.

The provided text discusses the impact of rising interest rates, especially on mortgage loans. When interest rates increase, banks raise the interest rates on their loans, including mortgages. This results in higher monthly payments for mortgage holders, and in the long term, it means they will pay more overall.

The interest rate predictions that imply the rise in interest rates also have negative consequences for potential borrowers. It can make it harder for them to access mortgage loans, particularly for those with lower incomes. This, in turn, may slow down the real estate market, as potential buyers may decide to delay purchasing property due to high loan installments.

Furthermore, the article highlights that long-term growth in interest rates can have a negative impact on the economy by affecting consumption and investments. When people have higher loan repayment costs, their ability to spend on other goods and services decreases.

In summary, the article emphasises that rising interest rates have wide-reaching effects, impacting borrowers, potential buyers, and the overall economic activity.