July 26, 2014

Interest Rates

Interest rates refer to the rate of interest paid by someone who borrows money from a lender. Imagine your are a small business and need capital from a bank to buy new promises for your business. The bank will then loan you the money required with a set rate of interest in order for them to be compensated for lending you the money. The rate of interest is usually expressed as a yearly percentage .

Effects of interest rates

The Bank of England uses interest rates as a means of keeping inflation low in order to preserve the value of your money. The repercussions of a rise in interest rates can be far-reaching. For example, the cost of borrowing is increased, mortgage and loan payments increase and returns on savings increase. Therefore, consumers will take out fewer loans if borrowing is more expensive and consumer spending will fall, or increase at slower rate. Similarly, mortgage repayments will increase and consumer spending will reduce. Finally, the increase in interest means savings become more attractive and spending is reduced as the money of savers is working harder for them in the bank.

The end result of the increase in interest rates will be that aggregate demand falls because spending and investment is down. This will reduce the rate of economic growth. The lower rate of growth can help to reduce inflation, which is a sustained increase in prices. Typically, a reduction in interest rates will result in the opposite of the above occuring.

APR and AER

Interest rates payable are usually denoted in Annual Percentage Rate (APR) or Annual Equivalant Rate (AER) terms. APR is usually used when describing interest rates on products such as mortgages, loans and credit cards while AER is for savings. This is because APR includes not only the rate of interest, but it also includes the charges involved. Contrastingly, AER only includes the rate of interest you will earn which is better aligned towards savings accounts.