Interest rates: the cost of money

Interest rates in simple terms

Interest rates are the cost of money if you want to borrow it from someone.

How much the money costs will depend on a number of things:

This is why interest rates vary depending on who’s borrowing from who, and for what purpose.

Quick aside- you may now be thinking ‘money doesn’t have a cost if I save it, then I’m getting paid for it’. Well when you save money, you’re the lender- the bank is borrowing it from you. They want to borrow it so they can go and lend it to other people. So the bank pays you an interest rate for it.

The very simple way banks work is that they borrow money from some people and lend it others for more. The people they borrow from are:

• us as individuals when we put our cash in their bank

• other banks

• Central banks (the Federal Reserve, the Bank of England etc)

Don’t Central Banks set interest rates?

Yes, they do. And that’s the starting point for all the other interest rates.

• The Central banks will set what’s called the ‘base rate’

• The base rate is the rate that banks pay to borrow money (so they can lend it to us and make a profit)

• When banks then lend out money to us (mortgages etc) they decide how much to charge based on how much they’ve got to pay to get their hands on that money

So as Central banks raise the base rate, they’re raising the cost of money to the high street banks. Which the banks then pass on to us as the new higher cost when we try to borrow from them.

That’s why when the Central banks raise the base rate, we see mortgage rates go up and vice versa. And we see the benefit in higher savings rates (because that’s us lending money to the banks).

Why have interest rates gone up recently?

Why would Central banks want to increase the cost of money? Because increasing the cost of money slows the whole economy down. If money is more expensive, people will borrow less. That means they build fewer new buildings, buy fewer pieces of machinery, hire fewer workers, and generally do less.

Why would they want to do that?! Because they need to try and control something very important; inflation.