What would happen to your finances if interest rates went up to 3%? We know that interest rates won’t stay at 0.5% forever. Where are interest rates headed, and what does it mean for you?

It has been 5 years since interest rates reached their record low of 0.5%. To be honest, back then I never would have imagined that interest rates would stay so low for so long. I don’t think the Bank of England thought they would stay so low for so long either!

This article will show you what 5 years of ultra low interest rates means for us. We look at where we are with the policy, where we are for you if you are a saver or a borrower, and what the future might hold for you.

Key points

  • What 5 years of low interest rates has meant for you
  • Who are the winners and losers?
  • Where is the economy now
  • What the future holds for interest rates

What 5 years of low interest rates has meant for you

The Bank of England base rate is currently at 0.5%. This is the record low point. Previously, interest rates have never been lower than 2%. Of course, in the not-too-distant past interest rates were much higher. Click here to view a great interactive chart of historical interest rates.

Back in 2008, when the banking system was on the verge of collapse, the Bank of England quickly reduced interest rates to try to bring some stability back into the economy. At the time, the economy was contracting quickly. As interest rates came down to nearly zero, it became apparent that they could not realistically go down any further.

This is when the Bank of England introduced quantative easing. This is sometimes referred to as ‘printing money’ but that description is a little wide of the mark. What the Bank of England actually did was to buy back certain Government debt (gilts). This was done to inject money into the economy, particularly in the financial sector. The aim was to boost demand, boost shares prices and confidence. I think we can now say that this policy has been a success. The economy did not go into meltdown.

Winners and losers

Broadly, we can divide the winners and losers of the policy into 2 camps – savers (and the retired) and borrowers.

Losers – Savers

If you are a saver, you have definitely lost out under the policy of low interest rates. Having said that, if the Bank of England had not taken such drastic action, the it could have been possible that you would have lost your savings entirely. They would probably argue that ultimately the policy has benefited you by keeping the banking system running and keeping your savings safe. But I’ll bet it does not feel that way.

If you hold any degree of savings in a bank account then you will have seen the interest rates come down to paltry levels. Almost all savings products are paying interest below inflation levels, which means they are losing money versus the cost of living. And most bank account pay tax, which further reduces the return you make.

In 2007 cash ISAs were paying around 5% interest, partly due to banks offering good deals to entice you to help them to rebuild their balance sheets. At that point if you were a saver, life probably felt easier. it was certainly an easy decision to keep your money in cash then.

Now the average interest rate on an instant access ISA is around 0.6% (source: BBC), which is lower than the current rate of inflation. You might be able to get better rates if you lock your money away for 5 years, but that would mean losing access to the money. Tweet this

If you have retired in the last 5 years you would have felt the pinch on your pension income. Retirement incomes from pension annuities are now at a low point, although they have recovered slightly in recent months.

What are your options if you are a saver?

  • Shop around
    If you want to keep your savings in a bank account then you should shop around regularly. Most banks pay introductory rates, which can catch you out if you do not keep an eye on the interest you are receiving. We regularly meet new clients who think that they are getting a better rate than they actually receive. They are shocked to find that they are getting rates as low as 0.2% per year! Don’t just use one website as your source since many comparison sites promote particular brands as they pay better commission.
  • Consider index-linked investments
    National Savings & Investments (backed by the Government) offer index-linked savings certificates from time to time. They are currently unavailable, but do offer you a secure way to beat inflation.
  • Take (slightly) more risk
    We often see savers who do not want to take much risk with their money. If this is like you, then you do not have to take high risks to get what you want. We work with clients who want to take a cautious approach, rather than investing in the stock market. We aim to help them to beat inflation, and achieve some real growth. Over the longer term, this can seriously boost your savings and income. See our Investment Management service for more details. Typical cautious investors take around a third of the risk of the stock market.

Winners – borrowers

If you are a borrower then you have probably benefited from the interest rates policy. Having said that, new borrowers have found it harder to get access to loans as banks made it harder to qualify for loans. Those with a large amount of equity in their homes have qualified for some very low mortgage rates in the last 5 years.

In 2008, the average fixed rate for a mortgage with a 25% deposit was 6.4% (source: BBC). Now the average is 3.3% for a 5 year fixed rate mortgage. This is extremely low, and far lower than historical averages.

Arguably, the biggest winners are those who in previous recessions would have lost their home through repossession. If you remember back to the mid-1990s, thousands of people lost their homes as the Government decided that this was a price worth paying to put the economy back on track. The Bank of England and Government took a different strategy this time around, though at the expense of savers.

Where is the economy now?

The source for this section comes from the Bank of England’s most recent inflation report. Remember that forecasts are not a guaranteed result!

Overall, the economy is growing but is still fragile.

  • Inflation at 2% target
    This has happened quite suddenly, and sooner than expected. There has been a reduction in oil and commodity prices. The value of the Pound is up versus other currencies, which has meant cheaper imports. The Bank of England is projecting inflation at around 2% over the next few years.
  • Economy growing
    The economy has grown by 1.9% in 2013, which is the highest rate for 6 years. The Bank of England is projecting growth in the economy of around 3% over the next few years. Apparently, there is spare capacity for growth at present.
  • Unemployment is down
    At present, unemployment is just over 7%, and the Bank of England projects this to drop to around 6.5% over the next few years.
  • Spending is up
    Credit has been easier to get (though not as easy as before 2008). Savings have been reducing as consumers spend.
  • Mortgage approvals are up
    The final quarter of 2013 saw mortgage approvals up by 25% on the same period the previous year. Levels of lending are still well down on 2008 levels, but the trend is upwards.
  • House prices are up
    Halifax says that house prices have risen on average by 7.9% over 1 year, although there are significant regional variations.

What the future holds for interest rates

The Bank of England is looking for the economy to grow further before they take any action on interest rates. Current predictions seem to centre around 2016 as the most likely point for a rise in interest rates. Of course, events could mean that this happens sooner. It is likely that interest rates would rise slowly to avoid any problems over repossessions of homes. The Bank of England says that interest rates are unlikely to return to their previous average levels of around 5%. Once interest rates start to rise you can expect that the Bank of England will start to reverse the policy of quantative easing. They would start to sell the gilts they bought in relatively small tranches. This should help to stop the economy from contracting.

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