Bank of England Base Rate change – what you need to know

THE DIFFERENT TYPES OF MORTGAGES:

Fixed-rate mortgage: The rate of interest is fixed for a period of time. No matter what happens to the Bank of England Base Rate during this period, the interest rate charged and the monthly mortgage payments will stay the same. When the fixed rate period comes to an end, the interest rate commonly changes to a Variable Rate.

Variable Rate mortgages: With this type of mortgage, the rate is ‘managed’ by the lender and will fluctuate from time to time. This will affect your monthly payments. Variable Rate mortgages fall into three main categories: 

• Tracker mortgages – the rate is variable and moves in line with a fixed economic indicator - usually the Bank of England Base Rate.
• Discount rate mortgages – these usually offer a discount off a lender's Variable Rate for a set period. As a result, you may have lower monthly mortgage payments during the discount rate period. 
• Standard Variable Rate (SVR) mortgages – this type of rate is managed by the lender and will move up or down according to market conditions (in most cases). 

Understanding the Bank of England Base Rate

It’s the phrase that we can’t seem to get enough of. As Google receives thousands of monthly searches, experts are besieged for advice and barely a day on Twitter goes by without it being mentioned. The Bank of England’s basic interest rate, also known simply as the Base Rate, has taken centre stage and is dominating the thinking on our financial future.

However it’s one thing hearing about the Bank of England Base Rate, but quite another to understand it. A good way to think of it would be as an air conditioning system in a domestic house. You turn it down when the temperature – or economy – falls, and you switch it up when the economy overheats.

In other words this Bank of England interest rate, bank rate or Base Rate (which for simplicity, we will refer to as the Base Rate for the remainder of this article) is a counterbalance to environmental conditions. In the world of the Base Rate, a lower number means growth is being targeted and a higher number means putting a lid on spending. Which is why, in the hands of the Bank of England, this virtual temperature control has become a significant way of maintaining a balanced economy.

So, how does this affect you? Well, all banks and building societies hold what are called ‘reserve balances’ with the Bank of England. The Base Rate is what the Bank of England pays out in interest on these balances, so that in turn affects what banks and building societies are prepared to pay their customers in interest. 

If the Base Rate is low then you might be more likely to spend rather than save – because interest rates, prompted by the Base Rate, don’t give you much of a return. Likewise, if the Base Rate is high then you might be more likely to save in order to see your savings rise. As a strong economy depends on people spending, you can see why people have latched onto the Base Rate as the answer to many of our economic ills.

It’s also why we’ve heard a lot about the Base Rate recently. It’s not just those with savings and mortgages that are affected. What brought it to most people’s attention was the economic downturn of 2008 when huge mortgage debts dragged down the economy. 

Fortunately the Bank of England acted swiftly at that point. It lowered its Base Rate in October 2008, first from 5% to 4.5%, then to 3% and 2%, all in the space of 3 months. Then in 2009 it took the rate down to 1.5%, still lower to 1% and then on to 0.5%. Never had the Base Rate dropped so low, which when you consider the history of the British Isles during 300 years of war, revolution and the Great Depression, is remarkable.

The history of the Bank of England Base Rate

From its origins in 1694 to the present day, the Base Rate has been vital to the UK economy. In fact, the rate was launched at the same time the Bank of England was founded – starting at 6% – and that’s no coincidence. In the middle of a costly Nine Years’ War with France, the government was looking to rebuild its finances. But its standing was so low that borrowing £1.2m from the public wasn’t an option. Instead, an independent bank was set up to induce subscribers and a rate of interest was set: hence the Bank of England came into being along with its own Base Rate. 

The first 100 years saw only three movements in the rate, far from the continually changing levels we see today. This lack of variation was partly down to a law banning the lending of money at unreasonably high rates of interest – known as ‘usury’. But it was also due to the relative lack of activity in a largely rural economy.

By 1847 the effects of the Industrial Revolution were showing in the lending requirements for new products and limited companies. From this time onwards the Base Rate began to move regularly. It went up to 8% and kept on moving significantly – both up as well as down. 

That was until the Wall Street Crash in 1921, when the plunging market required the Base Rate to head in the same direction. Then with inflation skyrocketing in 1981, the government headed by Margaret Thatcher took the Base Rate to its highest-ever level of 17%.

Another big rise came on Black Wednesday in 1992 as Britain fell out of the European Exchange Rate Mechanism, and then began the downward trend starting in 2008 when the Base Rate and the people who decide it came to the fore. Click here to see our Base Rate timeline.

Who decides the Bank of England Base Rate?

Not only is the Bank of England situated in the heart of London’s financial district, the City, it is also located right in the middle of the economy. That’s because its primary roles are to maintain monetary stability (steady prices and confidence in the pound) and to ensure financial stability (reducing threats to the economic system as a whole). The Base Rate sits under the monetary part of their twofold remit. For this reason, the decision on the rate has been assigned to the Monetary Policy Committee (MPC) at the Bank of England. 

Founded in 1997, the MPC comprises eight members, including the governor of the Bank of England, who meet every month to make a decision on policy. They choose whether to raise, lower or maintain the Base Rate at the same level, with three-and-a-half days given over to this conversation.

After 2009 this was a fairly easy call to make – keep it low for as long as possible to aid recovery. But circumstances have changed and the MPC has been toying with the idea of a small rise in recent months. What they’re taking into account is a slowly growing economy versus the effect the rise would have on homeowners. In theory, with higher interest rates coming into place on mortgage loans, some people could struggle to meet repayments.

Ultimately, the MPC has to make its decision based on future outcomes, with their decisions on the Base Rate taking a year to feed through to the system and affecting other aspects of the economy over time too.

The Bank of England Base Rate and the larger economy

The Bank of England’s main focus is maintaining the balance between demand for, and supply of, goods and services. When consumers have lots of money to spend, prices go up - then inflation takes hold because there’s greater demand for these goods. However, when times are tough, consumers tighten their belts and prices fall in a pattern known as ‘deflation’. 

That’s why the Bank of England has come to the conclusion amid this balancing act that an annual price increase of 2% is desirable for long-term growth. But how does this tie into the Base Rate? Well, a high rate encourages saving and a low rate motivates spending. The Base Rate is one of the major tools for affecting inflation, and because of that the Bank of England sees it as a vital cog in the economic machine.

The Base Rate affects other parts of the economy too. When saving is less rewarding, assets such as shares and housing gain in value. Homeowners may re-mortgage to increase their spending and shareholders may spend more as a result of greater wealth. 

The Base Rate even extends its reach to exchange rates. If interest rates rise in the UK, then investors would see a greater return on their assets relative to what they can earn overseas. So sterling becomes more valuable compared to other currencies and rises on the markets. This in turn makes imports lower in price and exports more expensive. The ultimate outcome is a reduced demand for UK exports.

A lower Base Rate should also boost those UK companies engaged in exporting to other markets. However, the Bank of England admits on its website that “the impact of interest rates on the exchange rate is, unfortunately, seldom that predictable.”

Wages and employment are also affected by a changing Base Rate, with inflation leading to demands from workers for a higher salary, which could reduce employment in the long term.

We’ve seen the lowest Base Rate ever in recent times, which the Bank of England said at the time of the historic reduction in 2009 to 0.5%, was as far as it would go: "a very low level of Bank rate could have counter-productive effects on the operation of some financial markets and on the lending capacity of the banking system", a statement read.

It’s why the Bank of England took on a programme of ‘quantitative easing’ in 2009, which is one way of describing the practice of essentially printing money. It was a last resort method for giving a final boost to the economy. 

Quantitative easing is easy to implement but it’s also a blunt instrument. The danger is that with excess money in the system, inflation can take hold – and the impact of quantitative easing is difficult to gauge. By contrast, although limited, the Base Rate is a refined and far-reaching way of adjusting the economic temperature. It allows us to pay the mortgage on our houses in more difficult times.

Courtesy: HSBC Bank

For more information:

Visit www.hsbc.co.uk/mortgages

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