Interest rates explained

Whether you’re applying for a loan or building up your savings, understanding how interest rates work is essential. But the variety of rates on offer can be overwhelming, so we’ve pulled together a guide to break down all the basics.

We’ll cover everything from how interest rates work to what causes interest rates to rise, as well as  how they might impact your everyday finances.

What are interest rates?

An interest rate is the fee charged for borrowing money or the amount you earn on your savings. It’s usually expressed as a percentage, and it signals how much you’ll be required to pay back or how much you might earn:

• Borrowing: When it comes to loans, mortgages, and credit cards, the interest rate is the fee you are charged for borrowing money. For instance, if you take out a loan for £2,000, and it has an annual interest rate of 10%, you’ll be required to pay back £2,200 after the agreed timeframe.
• Saving: When you save money, the interest rate signals the return you’ll earn. The higher the interest rate, the more money you’ll end up with. For 2025, the average interest rate sits at around 3.11% for an easy access savings account.

How are interest rates set?

In the UK, the Bank of England (BoE) sets the Bank Rate, which is the interest rate at which commercial banks can borrow money. Currently, the Bank Rate sits at 4.5%, with the next update scheduled for May.

Why do interest rates rise?

So, what affects interest rates, and why do they rise? Well, when the Bank Rate rises, the cost of borrowing also goes up, causing banks to increase their rates. Those rates are influenced by various factors, including:

• Supply and demand: Banks can also set their own interest rates based on supply and demand. For instance, if there’s limited money available but a surplus of prospective borrowers, rates may rise.
• Inflation: High inflation can also prompt the BoE to increase their interest rates. And if inflation is low, interest rates may be lowered to encourage spending and boost economic growth.
• Perceived risk: If a lender believes there is a higher risk that the money may not be paid back, they may charge a higher interest rate to the borrower to compensate for this.

Why do interest rates rise with inflation?

Interest rates tend to rise with inflation as the BoE uses them as a tool to control price increases. If inflation is too high, the BoE may increase interest rates to make borrowing more expensive. This helps to reduce consumer spending and, in turn, lower inflation.

Variable vs. fixed interest rates

Variable interest rates fluctuate in line with changes in the Bank Rate. Meanwhile, fixed interest rates remain the same over a set period, regardless of Bank Rate fluctuations.

Fixed interest rates make it easier for you to calculate your interest and repayments over time. They can offer protection from increases to borrowing costs. However, it’s important to bear in mind that you won’t benefit if the rate decreases.

How do interest rates affect borrowing?

So, what does it mean when interest rates go up? Well, when rates are high, borrowing money becomes more expensive. For instance, if you’re hoping to take out a mortgage to buy your first property, the interest rate will determine how much you’ll pay back over time.

Alternatively, when interest rates are low, borrowing becomes cheaper. Lenders charge less for loans, making it more affordable to borrow. So, whether you’re buying a house or financing a car, lower rates can make things more accessible.

When borrowing, you’ll often see the interest rate described as the APR (Annual Percentage Rate). This is your interest rate plus any other standard fees, giving you a complete picture of your borrowing costs over a year.

How do interest rates affect saving?

Interest rates also play a crucial role in saving and investing. When interest rates are high, you’ll earn more money on your savings, ISAs, and bonds. However, when rates fall, the return will be smaller.

If you’re saving for the future, it’s important to keep an eye on interest rates as they directly affect how much money you’ll accumulate. To make the most of your savings, shop around and choose the best account for your unique goals.

Will interest rates rise or fall?

The BoE regularly reviews the state of the economy and adjusts rates accordingly. And while we can’t predict how rates are going to rise and fall in the future, what we can do is stay informed.

Small changes can have a big impact on your finances, so it’s crucial to keep an eye on things.

Key takeaways…

Whether you’re borrowing money or saving for the future, understanding how interest rates work can help you make informed financial decisions. With this in mind, here are a few key takeaways:

• An interest rate is the percentage you are charged to borrow money, or paid on money you save.
• The Bank Rate determines the amount of interest paid to commercial banks, which influences the rates charged to borrowers and earned by savers.
• Variable or fixed rates may have different potential benefits based on your needs.
• Factors such as inflation, perceived risk, and supply and demand can influence interest rates.

Moneyboat are here to help

Unexpected costs can crop up at any time. From urgent car repairs to broken down boilers in the winter, emergencies can easily catch you off guard. But here at Moneyboat, we may be able to help in times like these.

We offer fair and flexible short-term loans with transparent terms, no hidden fees, and competitive rates. You can borrow between £200 to £1,500, then pay back the money in manageable instalments.

As a trusted UK direct lender, we carry out thorough affordability checks, ensuring you’re a good fit for the product and that you’ll be able to comfortably meet the repayments.

Alternatively, if it’s additional insights you’re after, you’ll find those over on the Moneyboat blog. Dive into our personal finance 101 guide or read our tips on managing your personal cash flow.