Interest rates explained: A helpful guide for your clients

Your clients have probably noticed that the prices they pay at the supermarket and many other places have increased sharply in recent years. But do they understand why?

Interest rates have risen 14 times since December 2021, and they are expected to remain higher for longer as the Bank of England (BoE) tries to reduce inflation.

These changes to the bank rate are having a significant impact on the cost of living, which may be causing many of your clients to feel undue financial pressure.

Yet, according to IFA Magazine, almost a third of people do not understand the impact of interest rates on the cost of borrowing money. And research published in FTAdviser has revealed that the same number of people don’t know what interest rate they’re getting on their savings.

So, read on for a simple guide that could help your clients understand interest rates better, which might enable them to manage their money with greater confidence.

How interest rates work

An interest rate determines how much it costs to borrow money or how high the rewards for saving are.

The BoE sets the base rate, which is the most important interest rate in the UK as it influences many other interest rates in the economy.

If the BoE feels inflation (the rate of increase in prices) is rising too quickly, it may try to manage this by increasing the base rate as it has done many times between 2021 and 2023. Higher interest rates help to slow down inflation by encouraging people to save rather than spend. In turn, the hope is that this will slow down demand for goods and services and help to bring prices down.

If the base rate increases, the interest on savings and loans typically increases too. So, it would cost more to borrow money, but you could potentially earn more interest on savings. If the base rate decreases, other interest rates will usually follow suit.

For example, after the BoE increased the base rate for the 12th consecutive time in June 2023, the Guardian reported that UK savers were benefiting from the highest rates on savings accounts for more than a decade.

It’s worth noting that an interest rate is different from other charges such as the APR and AER, although some people mistakenly use these interchangeably. The Annual Percentage Rate or APR is the interest rate plus any fees that are added to your loan and the Annual Equivalent Rate or AER shows you what you could earn from your savings over a year by factoring in compound interest (more on this below).

It’s important to understand how interest rates work and how they differ from other charges to help you make informed decisions about your money.

Fixed and variable rates of interest

A “fixed” or “variable” interest rate will apply to any savings and loans you have.

A fixed rate is unaffected by changes in the base rate. You’ll earn or pay the same amount of interest for the full term of the fixed rate. This could help you to calculate the interest you’ll earn or the repayments due over time, which may make it easier to manage your finances.

Variable interest rates can go up or down depending on the base rate and other factors. So, you could earn more interest on your savings if interest rates increase. However, the repayments due on any loans you have could also go up.

The power of compounding interest on savings and loans

Compound interest is the interest on the initial savings or loan amount plus the interest that has accumulated over previous periods. This “interest on interest” can have a powerful snowball effect on the total amount of both savings and debt.

In other words, compounding could make your savings and loans grow at an accelerated rate.

For example, if you put £1,000 in a savings account that offered a 2% interest rate, you could have £1,020 after 12 months.

The table below shows how compounding could grow your savings at different rates of interest.

Source: Moneyhelper

Although the increase in savings may seem relatively small, over time and as you add to your balance, compounding could make a significant difference to the amount of interest you earn.

Similarly, it could also increase the amount of interest you pay on loans over several years.

Interest rates could affect your tax bill

As interest rates are higher than we’ve seen in more than a decade, many people are paying tax on their savings interest for the first time in a long time.

If you are a basic-rate taxpayer you have a Personal Savings Allowance (PSA) of £1,000 (2023/24). This means that you will not have to pay tax on any savings interest you earn up to this amount.

If you are a higher-rate taxpayer, your PSA is £500. Additional-rate taxpayers do not have a PSA and must pay tax on all interest earned from savings.

You could protect some of your savings from tax by using your annual ISA allowance, which is £20,000 for the 2023/24 tax year. You can split your allowance across different types of ISA and there will be no Income Tax or Capital Gains Tax to pay on savings held in an ISA wrapper.

Get in touch

If your clients would like to learn more about how to save in a tax-efficient way, they should email mail@delaunaywealth.com or call us on 0345 505 3500.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.