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Base interest rate

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What is a base interest rate?

A base rate is the interest rate central banks, like the Bank of England (BoE) in the UK, will charge commercial banks and building societies for loans. The base rate is also known as the bank rate or the base interest rate.

Central banks will use the base rate to either encourage or discourage spending. A change in Bank Rate affects how much people spend, and how much people spend overall influences how much things cost.

When commercial banks decide what rate to charge on loans and offer on savings, it’s usually based on what base interest rate has been set by the central bank.

How does the base rate affect interest rates?

The base rate will impact the interest rate consumers receive, because commercial banks will usually alter their interest rates in line with any changes put out by central banks.

If a central bank increases the base rate, commercial banks will increase their interest rates so borrowing becomes more expensive. If the base rate falls, the opposite is true and spending is likely to increase.

How does the base rate affect inflation?

In the UK, the Monetary Policy Committee (MPC), which are part of the Bank of England (BoE), take the appropriate measures to make sure the rate of inflation is kept within the government’s inflation target. The current target is 2% based on the Consumer Prices Index.

One of the best ways to try and maintain a steady inflation rate is through controlling interest rates. When the BoE are setting the base interest rate, they’ll need to think about how it can affect inflation. The base interest rate will influence different banks and building societies on what they’ll charge people to borrow money, or what interest they’ll pay on people’s savings.

Central banks often look to raise interest rates when inflation is rising and lower rates when inflation is falling, or prices are declining – also known as deflation. Lower interest rates can help stimulate the economy through encouraging more spending.

How does the base rate affect borrowers and savers?

Broadly speaking if the base rate is lower this is good news for borrowers as the interest you pay back will be lower. But when the base rate is higher, this is good for savers as you earn a higher rate of interest.

However, it’s important to remember if a central bank reduces the base rate, banks would also likely reduce their lending rates and rates for mortgages. This means it could be easier to get a loan. Mortgage rates could also become more favourable for buyers. On the other hand, lower base rates could also mean you could get lower returns on your savings as interest rate payments decline in value.

Both factors have tended to encourage consumers to spend more in the economy as keeping your money in a savings account becomes less attractive.

If a central bank increases the base rate, borrowing could become more expensive and mortgage rates could increase. It could also mean consumers save more and spend less. All of which is more favourable for the banks.

On the other side of the coin, any savings that are held in interest-based accounts would see greater returns on the interest payments in line with the increase in the base rate.

For example, after the 2008 financial crisis, lots of central banks kept base rates low. This in turn led most commercial banks to charge low interest rates on loans to customers, but also offer low interest rates on money held in interest-based accounts.

With the cost of borrowing low and the benefit from saving minimal, consumers would, in theory, be encouraged to spend money instead of saving it. This in turn would boost businesses and the economy.