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What an interest rate rise means for your money

Finally, after six years, the Bank of England wants to raise interest rates. What's the impact on our ISAs and pensions?

What an interest rate rise means for your money

Interest rates have been frozen at a record low of 0.5% for six years. Now the Bank of England wants to raise them. This video explains what's happening and what it means for our ISA and pension savings.

This video is part of the Lolly Investor Programme, a regular series aimed at beginner investors.

Can't watch now? Read my script

Most of us probably can’t remember the last time the Bank of England raised interest rates!

It was eight long years ago in July 2007 – when Rihanna topped the charts with ‘Umbrella’ – when the Bank’s monetary policy committee lifted the UK base rate to 5.75%.  It had to quickly reverse the move and slash rates to just half a percentage point in March 2009 as the banking crisis turned into a Depression.

The Bank’s governor, Mark Carney, has stated this long period of low interest rates is finally ending. Speaking at Lincoln Cathedral Carney said he expected the first interest rate rise to come around the end of this year.

Janet Yellen, who chairs the US Federal Reserve, indicated the world’s biggest economy could see its first rate rise in nine years in September.

The last time US interest rates rose was in July 2006 when they reached 5.25% before crashing to near zero in December 2008 where they have remained.

The good news is that the economies of both countries are ready for an increase in the cost of borrowing.

In the UK unemployment has fallen to 5.5%; the economy is growing at nearly 3% a year; and people are starting to feel they’ve more money in their pocket as a result of low inflation.

In the short term all this is great news if you’re going for a holiday abroad, particularly in Europe.

That’s because the prospect of higher interest rates in the UK has made the pound more attractive.  Sterling has soared against the euro.

In theory, the big winners from a rise in interest rates are savers who have endured pitiful rates on their cash ISAs, which today yield less than 1.5% on average!

By contrast, investors in stock market ISAs and pensions have done better from another measure in the Bank of England’s emergency response to the banking crash.

That’s ‘quantitative easing’ or QE – the policy by which the Bank created £375 billion out of thin air and used the money to buy government bonds. It did this in order to keep long-term interest rates low, as well as the short-term base rate.

All this QE money found its way into the stock market and the housing market.

The worry is that some of these gains might unwind as central banks ‘normalise’ monetary policy.

There’s a consensus that stock markets have got ahead of themselves in recent years.

Although the world economy is recovering from the financial crisis, it’s a weak recovery that doesn’t support high share prices.

Meanwhile bonds – or fixed interest stocks – from governments and companies look expensive. Bonds could be in for a rough time as interest rates rise, particularly if the Fed hikes its funds rate faster than expected.

The pace at which central banks raise interest rates rise is key to their impact.

I said cash savers should in theory benefit from higher interest rates. In practice, however, the Bank of England is determined to lift rates very slowly.

That’s because debt levels in this country are high.

Because we generally borrow more than we save, raising interest rates by 1% cuts household spending by 0.5%, which slows down the economy.

But the real worry is what happens to people who are deep in debt. They’d have to cut spending, work harder or move home to get by.

That could be bad for the economy if banks are hit with rising loan losses as the number of borrowers in arrears rises.

We shouldn’t be too worried about another banking crisis, however.

Rising interest rates are good for banks as their profit margin between the rate they pay savers and the rate they charge borrowers rises.

To conclude, rising interest rates are a sign of a growing economy which benefits us all.

But if the Bank of England gets its way interest rates will not near their 4.5% long-term average for a very long time. Carney wants interest rates to peak at around half that level in the medium term and it may take well over a decade before they go above 3%.

So don’t hold your breath for better cash ISA rates but do hold out for good long-term returns from the stock market, once we get over what is likely to be a volatile period for bonds and shares.

4 comments so far. Why not have your say?

Alan Tonks

Jul 23, 2015 at 19:27

Oh they are really coming thick and fast now., Mr bubble Carney crying wolf again, but in this story the wolf dies of old age.

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Jul 25, 2015 at 16:33

What do you mean "Finally, after six years, the Bank of England wants to raise interest rates."?

It's BS! They've almost constantly been saying there will be a future interest rate since 2009! When the governor says there will be an increase in interest rates in the future it instantly increases the value of the pound, this is more likely the reason, currency exchange manipulation.

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Trevor Smith

Jul 26, 2015 at 11:12

Bank of Enland raises Bank Rate!

Corporate bond prices fall to reflect this

Some pundits are predicting a stock market "adjustment" and some Fund managers are selling holdings in high dividend stocks such as BP

If I decide to sell my bonds before this happens where can I therefore reinvest to replace a goodly proportion of the income earned on the bonds?

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Rose G

Aug 24, 2015 at 16:47

I am happy to state that I am lucky not to have been bitten by the gambling bug; investing on stock markets is in effect a gamble; value of shares may go up as well as down; unfortunately, in today's corrupt society, these are some of the highest paid individuals who are paid obscene amounts of money in wages, in bonuses, in knighthoods - what does this say about those who work in these areas? Corruption is endemic, but as long as they keep getting away with it, nothing will change. most obscene of all is that governments have used taxpayers money to bail out greedy fraudsters - what does this say about the society where jobless are going to food banks, while bankers are enjoying the corrupt lifestyles even as countries face huge bills for QE - how come there is always money for bank bailouts or to wage war, but never enough to provide decent education, building decent low cost homes or funding health care?

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