Q&A - What is an interest rate?
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An interest rate is the cost of borrowing money or the return for investing money.
For example, a bank charges interest on amounts loaned out or on the balance of an overdrawn bank account. A bank will also pay interest to the owner of an account with a positive balance.
Interest rates vary depending on the type and provider of borrowing.
The base interest rate in the UK economy is set by the Bank of England. Each month, the Monetary Policy Committee of the Bank of England to decide what the base rate should be. During the credit crunch, the base interest rate has fallen sharply to as low as 0.5, as shown in the chart below:
The base interest rate set by the Bank of England affects other interest rates in the economy because it is the rate at which banks can themselves lend from the Bank of England.
In theory, a lower base rate will lead to lower interest rates on borrowings paid by businesses – but not necessarily.
The effect of a change in interest rate will be affected by whether borrowing is at a variable or fixed rate:
With a variable rate, the interest charged varies in relation to the base rate. So a fall in the base rate to 0.5% in early 2009 should mean that businesses with variable-rate overdrafts pay lower interest.
A fixed interest rate means that the interest cost is calculated at a fixed rate – which doesn’t change over the period of the credit, whatever happens to the base rate.
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