Understanding interest rates

There are many different types of interest rate used in everyday life.

Loan interest rate

When borrowing capital, lenders will charge you an interest rate, quoted as a percentage of the principal loan capital. The repayment process can vary:

• Interest and capital are repaid at the end of the loan term – e.g. bridging loans
• Interest is repaid each month and capital at the end of the term – e.g. interest-only mortgages
• Monthly instalments covering interest and part capital repayments – e.g. capital repayment mortgages

The interest rate will reflect the risk associated with the borrower and their ability to repay the capital and interest.

Rental/lease interest rates

Rental and lease interest rates are also a form of charge directly related to the value of the asset. For example, a company may lease an office on a 5% rental yield. This means that the party renting will have use of the office premises in exchange for an annual rent equal to 5% of the value of the property. The owner of the asset would need to take into account the creditworthiness of the party borrowing their asset.

Savings interest rates

When holding funds in a savings account, savers are paid an interest rate on their account balance. In the UK, this rate is heavily influenced by the Bank of England base rate, which is the rate the Bank of England charges UK banks for secured overnight lending. The savings rate for consumers is also influenced by how the bank can invest these funds to create a greater return. In simple terms, where an individual or company borrows an asset, the interest or rental charge is both:

• A cost to the borrower
• A return to the lender

How does inflation impact interest rates?

When looking at the headline interest rate of any transaction, this doesn’tconsider inflation. The rate of inflation is an official measurement of the rise in the cost of living. This is calculated by tracking the price of UK household essentials across a range of goods and services, including:

• Food and beverages
• Alcohol and tobacco
• Clothing and footwear
• Housing and household services
• Furniture and household goods
• Health
• Transport
• Communication
• Recreation and culture
• Education
• Restaurants and hotels
• Miscellaneous

Source: ONS

Headline returns vs Real returns

The best way to demonstrate the effect of inflation is to look at loan interest rates and inflation. Let’s assume a £10,000 loan over 12-months, with the principal and interest repaid at the end of the term. Loan principal: £10,000 Loan interest rate: 5% In this example, an individual would repay £10,500, including interest, upon the expiry of the loan agreement. The gross return would be £500, i.e. the interest paid. If we now consider inflation:

Inflation rate one: 10%

If we use a 10% rate of inflation then in simple terms the spending power of the original £10,000 would reduce by 10%. This equates to spending power at the end of the 12 months of £9000 – a real loss of £1000 in spending power. However, if we add in the £500 interest earned over the 12 months, this reduces the real loss to £500.

Inflation rate two: 3%

With a 3% rate of inflation, the relative spending power of the original £10,000 will fall to £9700 at the end of the loan term. This is a real loss in spending power of £300. However, adding the £500 interest earned over the period takes the real loss from £300 into a real gain of £200. A lower rate of inflation creates an increase in the real spending power of the original capital.

Conclusion

While the Bank of England base rate will heavily influence interest rates on loans and assets, there is also a need to consider inflation. If the cost of living grows by a more significant amount than the interest charged on a loan or an asset, the relative value of the asset is falling. Several other factors may ultimately influence the interest rate a bank or lender may offer, such as the specific risk associated with the borrower.  There is a lot to consider!