How Rising Interest Rates Affect Your Finances

The sharp increase in food and energy prices has made inflation a talking point, and a concern, across the nation. We look at the impact of inflation upon your finances. 

When inflation increases, the Bank of England increases their interest rate. Because banks borrow from them, they have to pass this on. This increases the cost of borrowing, encourages saving and reduces economic activity.
 

Secured Debt 

Higher interest rates drive up mortgage costs for homeowners. For example, if you have a £200,000 mortgage on a 2% variable rate, the monthly payment is around £843. If rates rise to 3%, the monthly payment increases to approximately £917.  

Higher rates can also impact the ability for first time buyers to get on the housing ladder. This can be seen in their increasing average age. 

It is sensible to build in a potential rate rise to the household budget when considering a mortgage.  

Unsecured Debt 

Interest rates on unsecured debt can often be increased more quickly when the interest rate increases. 

For instance, if you have a £5,000 balance on a credit card with a 10% APR, you currently pay £42 in interest per month. If the APR rises to 15% due to higher interest rates, the monthly interest owed increases to £63.  The increased cost of servicing debt reduces disposable income that could be saved or invested.  

Instead, look to consolidate and reduce debts with the aim of paying them off entirely.  

Savings Accounts 

A higher interest rate is positive for savers. This allows your money to grow faster in regular savings, cash ISAs and fixed rate bonds. 

For example, if you have £10,000 in a savings account earning 0.5%, you make £50 annually in interest. If the interest rate rises to 1.5%, you would earn £150 annually on the same balance – tripling your earnings.  

Consider moving funds to accounts offering best returns. But be aware of what inflation is doing. If inflation exceeds interest rates, then purchasing power will decrease over time.  

Therefore, whilst you should always maintain a suitable cash reserve, be wary of holding too much cash for the long term.  

Investments 

“Businesses and bricks” are two important methods to build wealth. Both benefit from a rising income so they also benefit from a rising value. 

Companies often cope well with rising inflation, by passing on the costs. They are one of the few investments that are likely to outperform inflation over the long term.  

Property tends to be bought by secured debt, so increasing interest rates will decrease the net return. However, rental income tends to increase when interest rates increase, albeit with a delay.  

Gilts and bonds (loans to companies and governments) are often used to reduce volatility.  However, they lose resale value when interest rates increase. This is because their interest rate is fixed so something has to give for them to remain an attractive investment. But they do tend to bounce back when rates start to decrease.  

On the positive side, annuity rates also rise with interest rates. This means converting a pension to an annuity income provides higher payouts. If you are near retirement, obtain up to date annuity quotes. 

Therefore, manage your mix between the above asset classes carefully.  

The Rising Cost of Living

A consistent consequence of higher interest rates is increased cost of living. From mortgages to credit cards to purchase loans, borrowers pay more which reduces disposable income. This strains household budgets.  

Be proactive about budgeting and money management to weather tighter times. Seek ways to reduce debt, grow savings and alter spending to take control of your situation. Consider lifestyle changes to adapt.  With prudence and patience, your finances can persevere. 

To fully understand how your finances are impacted by movements in UK interest rates and to achieve your financial goals, speak to a financial adviser. Our team of multi awards winning Chartered Financial Advisers can help you.