What is Interest and Why is it Important?
Interest, in a nutshell, can be described as the "cost of borrowing money". When people need money they approach the bank for a loan. The bank affords them the loan provided they have a good credit score. However, this money isn't handed to the loanee freely, there is an interest charged on a 12-month loan.Some people have extra money lying about. Instead of keeping it locked up in their closets, they can opt to put it in the bank. The bank then essentially borrows this money. This money is borrowed at a certain rate of interest for which the bank pays you yearly.
A point to note is that the rate of interest on a 12-month loan is much higher than the rate of interest on a 12-month deposit. It is by using this spread that the bank makes some of its main profits. The reason why interest is useful is that the government can use it as a tool to prevent inflation or help spur the economy by encouraging borrowing.
How is Interest used to Reduce Inflation?
During positive times when people have money to spend, the cost of commodities goes up due to the increase in demand, also known as inflation. If the interest rates at this point are increased, borrowing money from the bank will become more expensive, and people will get better interest rates on their deposits. This is how banks can curb inflation.How is Interest used to Boost the Economy?
If the interest rates are decreased when the economy is down and people cut down on their expenditures, people will be encouraged to increase their spending. More consumer expenditure means that more jobs and profits will be generated, and this serves as a boost to the economy.Who sets the 12-month Loan rate of Interest in the UK?
All banks that lend money have to take a loan from the government bank. This bank is known as the bank of England. Therefore, the interest rate in the UK is set by the Bank of England. This rate is sometimes referred to as the repo rate or the base rate. The base rate is the 12-month loan interest rate at which commercial banks borrow from the Bank of England. Therefore it is the bank of England that sets the level of interest all other banks charge borrowers.
If the Bank of England increases its repo rate, commercial banks also tend to increase their interest rates. However, this doesn't mean that commercial banks are required to mirror the 12-month loan rate set by the bank of England.
Money can be borrowed for different periods, most commonly as a 12-month loan or 1 year. Banks can, therefore, make a comfortable profit on the cash generated from charging interest.
What Affects the Interest Rates for 12-month Loans?
Changes in the interest rate charged by the Bank of England are made by the Monetary Policy Committee of England. The Monetary Policy Committee is a body that meets every month to decide if there is any need for change in interest rates.Several factors affect the interest rates charged by the bank of England. Some have a global impact, while other factors are caused by internal circumstances.
International Factors
- Wage rates – If people start earning more, they will naturally have more money to spend. This means that the demand for different commodities will increase. As the demand for essential items increases, the prices will go up accordingly. As a result, there will be overall inflation in prices.
The government and the Monetary Policy Committee set a yearly inflation target. If the inflation rate goes over that target, there is an increase in interest rate.
- Commodity prices: Changing the oil prices, cost of items such as gold and silver, and of construction materials and a host of other commodities have an effect on the inflation of a country.
- Consumer spending levels: When consumer spending reaches concerningly high levels, the Bank of England steps in and increases the 12-month loan interest rate. The changes can be seen in the consumer industry, and the inflation rate will correct itself.
- Investment levels: An increase in FDI will cause an increase in the demand for the currency of the receiving country. A rise in its exchange rate will take place. In addition to this, an increase in currency value will lead to an improvement in trade. The trade deficit, which is the difference between exports to imports, will also be reduced.
With all other factors being equal, a higher value of the currency will prompt the national bank to increase the bank rate for 12-month loans.
Factors that vary from person to person
When you approach a bank for a 12-month loan, you'll notice that the interest you are being charged is higher than the Bank of England repo rate. However, this is done so that the lending bank can account for the risk involved in lending you the money.Some other factors also influence the 12-month loan interest rate that might vary from person to person. One of the key factors is your uk credit score. Simply put, the better your credit score is, the lower the interest is on the loans you want. This is why it is paramount to have a good credit score.
Apart from your credit score, other factors that influence the interest rate you might get on a loan are:
- Repayment history: A good repayment history often works well for applicants seeking loan approval.
- Defaults: Presence of defaults in credit profiles does not only prompt higher rates of interest but also leads to rejection.
- Employer reputation: Another aspect that affects interest rates is the employer's reputation. Applicants employed by big organizations are often offered lower rates.
