How interest works: The Hodge quick six 

As the Bank of England (BoE) base rate hikes to its highest since 2009, savers and spenders across the UK are performing balancing acts with their finances. In a volatile economy, we may all feel at the mercy of rising interest rates and their knock-on effect on borrowing and saving.  

Hodge consumer research discovered that 81% will put less cash into savings this year as living costs continue to weigh heavily on our minds and wallets. The juxtaposition is that higher interest rates can offer higher rewards for savers. This Hodge quick six will look at the basics of how interest rates work, why they’re increasing and most importantly, why they matter to you and your finances.  

1. What’s an interest rate? 

An interest rate is the percentage of the price you pay on what you borrow or the reward you will receive for saving. For example, when taking out a loan, you’ll pay back the original value of the loan plus the interest. If you’re saving, the interest rate will be how much money you will earn as a percentage of your total savings. 

2. How are interest rates in the UK set? 

The Bank of England sets the bank rate or base rate for the UK. Several influencing factors determine the rate set by an independent group of economists working with the BoE. Rising inflation and increased cost of living will usually lead to an increase in interest rates.  

The base rate rose to 1% in May 2022, the highest it’s been for more than 13 years when it spiked as high as 5.75% between 2007 and 2009 during the global financial crisis.  

3. Why have interest rates gone up? 

In the UK and worldwide, we’re seeing an increase in the price of goods and services, increasing the cost of living. This increase causes the value of your money to decrease and leads to inflation. Inflation is a key indicator that the economy is overheating. To control inflation, the Bank of England has increased interest rates to stabilise borrowing, slow the rate of price increases, curb spending and boost saving. The BoE has a target of 2% or lower for inflation rates. Inflation is at its highest for 40 years at over 9%. By increasing interest rates, among other measures, the UK Government and BoE aim to reduce inflation back to 2% by 2024. 

4. How do interest rates affect me? 

Even a slight change in interest rates can have a significant impact on your finances, so being aware of how these can affect you could save you cash in the long term.  

The interest you pay or earn can be different if the interest rate changes, or the balance you owe or have in  savings fluctuates during the period the interest was calculated. Rising interest rates can make borrowing more expensive but can be good news for savers who could earn a higher interest rate on cash in their savings accounts. 

5. How is interest paid on my savings account? 

Each bank or building society will offer different interest rates. Depending on the savings account, you’d be paid a fixed rate or a variable rate of interest. A fixed rate account, such as a fixed rate ISA (Individual Savings Account) or fixed rate bond, will offer you a guaranteed percentage for the term of the account. A change in interest rates set by the Bank of England will not affect this. If you have your money in a variable interest rate account, the interest you earn could fluctuate along with the Bank of England base rate, or may slightly increase or decrease or not change at all. It all depends on the lender.  

A savings account will usually earn interest every day, but it is generally paid back into your savings account monthly, although some accounts may pay quarterly or even annually. You can ask your provider if you are unsure how often interest is paid on your account. 

6. Can my savings take advantage of rising interest rates? 

Make sure you shop around for the best deal and regularly compare savings accounts to see who is offering the highest interest rates on savings accounts that work around your financial goals. In most cases, it only takes a few minutes to open a new account online and you can usually move your savings pot (if there are no penalties to switch from your existing account) to the new provider. Make sure you take into consideration your short- and long-term financial circumstances as this may determine the type of savings account you choose. If you’re prepared to lock away your savings, a fixed rate bond or fixed rate ISA will often offer you better deals but won’t be the right product if you need instant access to savings.  

Hodge has a range of fixed rate ISA and fixed rate bonds with competitive interest rates. It’s free to open and you can apply online in under 10 minutes.