Interest is paid on deposit based investments and charged on borrowing. Interest on borrowing is generally higher than on deposits giving the financial institution a margin. Interest on borrowing can be expensive the higher the risk to the lender such as unsecured, as unsecured lending is only a promise to pay by the borrower.
On deposits the rates offered are higher when the risk is greater for the investor, generally speaking the longer a depositor invests their money should yield a higher return as they relinquish access to their investment for the duration and lose the opportunity to invest elsewhere. Tax rates should also be considered on deposits, as the return is the net amount after tax i.e. a 5% rate is worth 4% for a BRT payer, 3% for a HRT payer and 2.75% for an ART payer. The ‘real rate of return’ is broadly speaking the interest rate less the inflation rate. Interest can be calculated as Simple (% added to the original investment) or Compound (% added to the original investment plus previous percentages added).
From April 2016 a new Personal Savings Allowance (PSA) will be introduced. Interest from bank and building society accounts will be paid gross. The following tax payers will receive the following amounts of interest tax free:
- BRT payers will be exempt from income tax on the first £1,000 of annual savings interest.
- HRT payers will be exempt from income tax on the first £500 of annual savings interest.
- ART will not benefit from the savings interest exemption
Interest rates can affect many aspects of the economy; rising rates can cause variable rate mortgages to rise, leaving consumers with less disposable income that in turn can lead to a slowdown in the economy. UK trade can also be affected by rates as there is a relationship between currencies and interest rates. High UK interest rates can lead to a strong pound making UK exports more expensive for foreign buyers.
Many believe that when rates rise it is the government forcing consumers to pay more. The Bank of England (BOE) set UK rates and is independent to the government. The BOE has a responsibility to maintain price stability that can involve stimulating or calming the economy through monetary policy. The responsibility of setting interest rates was passed to the BOE in 1997. The Monetary Policy Committee (MPC) sets rates; this is made up of a 9 member committee (including the governor). They meet 8 times a year to set the BOE RATE, the MPC have an inflation target to maintain which is CPI at 2%, with up to a 1% divergence either side. The only organisations that benefit when rates rise are banks and building societies, as the spread between what they pay on deposits compared to loans widens. It is depositor’s money that is lent out to consumers requiring loans and mortgages. The government essentially would prefer low rates as this would mean lower interest payments on government borrowing and consumers spending more helping businesses to thrive.
Interest rates are fundamental to the economy, as changes in rates affect where investors place their money. When rates are low asset backed investments tend to do well, however over time having it too good can lead to inflation which will then result in rates having to rise to calm the economy.