Monday, September 19, 2011

How Interest Rate Affects Savers and Borrowers

Readers Question: “how does the current interest rate affect the savers and the borrowers?”

The current Bank of England base rate is at a historical low of 0.5%.
  • A low interest rate means savers gain a low return (interest payments) on their savings
  • A low interest rate means borrowers will pay a low interest payment on their debt.
Traditionally you would expect this kind of interest rate to discourage saving and encourage borrowers.

Low rate of return for savers. 0.5% is a very low interest rate for savers. With CPI inflation at over 4%, this means there is a negative real interest rate. Therefore, savers are seeing a decline in their living standards.

In theory, this low rate of interest would encourage savers to spend rather than save. However, the continuing recession and threat of unemployment is discouraging spending. But, given the low rates of interest savers have been encouraged to find alternative forms of investment than bank accounts. It is one factor behind the increase in demand for gold.

Despite the ultra low interest rates, saving rates have actually increased. This shows that the interest rate is only one factor that determines saving rates. Saving rates have increased in UK and US because:
  • Banks have encouraged saving to improve their balance sheets.
  • Banks give a commercial interest rate substantially above the bank of England base rate.
  • Confidence. One of the key factors determining saving rates is expectations of the future economic situation. With spending cuts, rising unemployment and fears of a double dip, it is unsurprising there has been a preference for saving rather than spending.
  • Change in Attitude. Before the credit crunch, the UK was a nation of borrowers. The saving rate was very low and debt levels high. The financial squeeze has to some extent changed attitudes to saving and debt. (borrowing v austerity)
The very low interest rates is a reason why government in the UK and US (outside the Euro) have been able to borrow large amounts at low interest rates.

In theory, this is a good time to be a borrower. Interest rates are very low so interest repayments are a smaller % of income. This makes it easier to meet mortgage repayments. Low interest rates is one reason why home repossessions have been lower compared to the last recession (in 1991 where rates reached double figures)


1 comment:

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Interesting insight on the aspect of confidence with banks. You got the gift of gab in sharing economic jargons with such flair for a financial-dummy guy like myself to understand. Please keep on sharing. Cheers.