The Economy: 2. Interest Rates and Mortgage Rates

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BBC Sounds, music, radio, podcasts.

Welcome to Understand the Economy, the show that takes you back to basics and explains the way economics affects our everyday lives.

We've already covered inflation.

You can find that on BBC Sounds.

Subscribe and download and get in touch using the hashtag understand the economy.

We want you involved.

Today, interest rates.

What are they?

Why do they go up and down?

Who makes them go up and down?

And how and why do they affect mortgage repayments?

First, what is an interest rate?

An interest rate is the price of borrowing money over time.

If I borrow £100 for a year, at the end of the year, I obviously have to pay the £100 back.

And if I borrowed from a friend, maybe that's the end of it.

But if I borrowed from a bank, or using a credit card, or from a payday loan company, well, they're going to want to be paid for their trouble.

So I might have to pay back the original £100 plus £10.

That would be an interest rate of 10%.

Percent literally means per 100.

A mortgage interest rate might be just a few percent.

A payday loan interest rate might be over 100%.

And interest rates aren't just about me borrowing money from a bank or such like.

I could also lend money to the bank by putting it into a savings account.

Then the bank pays me.

It's the same deal.

Although somehow the interest rates you receive as a lender never quite seem to be as high as the interest rates you pay as a borrower.

Richard Davis is back on the show.

He's an economics professor at Bristol University and director of the UK's Economics Observatory.

Richard, why do banks charge us interest rates?

It's the way they make money, quite simply.

They gather money from us as depositors and then they lend it out in the the form of loans, credit cards, mortgages and other types of loan.

And the difference in the interest rates that they charge is one of the main ways that they make money themselves.

There is another reason though, and that is risk.

So if you think of a high street bank that's giving out personal loans, it makes a hundred personal loans.

Somebody in that 100 is likely to lose their job, fall ill, come across some other reason that they can't pay back that loan.

The interest rates that that everybody else pays act as a kind of buffer which cover the bank's losses on that loan.

Time for a bit of history.

Why is it called an interest rate?

The word comes from a Middle English word, interesse, meaning what one has a legal concern in.

Please, Middle English nerds, don't write into me about my pronunciation.

I'll let an economic historian do the rest of the history.

Here's our resident expert, Cambridge University's Dr.

Victoria Bateman.

So all major religions of the world historically contained usury laws, and these usury laws limited the interest

that lenders could charge to people who wanted to borrow.

So the Industrial Revolution leads to a birth of new exciting types of goods and also machinery too.

So if you take something like a steam engine, a newfangled machine, banks were not familiar with this.

This was an entirely new invention.

So the idea of lending to fund something like the building and the rollout of steam engines seemed really, really risky.

And so if you were a bank at the time of the Industrial Revolution, you were reluctant to lend to an industrialist.

Instead, you'd much prefer to lend to a landowner, to lend on the basis of something solid, land.

If the landowner defaults, you can get your money back in the form of land.

If someone building a steam engine defaults and doesn't give you your money back, you're left with a newfangled steam engine that you don't know how to work, you don't know whether anyone else will want to buy it from you.

And doubly so, because banks were limited in terms of the interest rate that they could charge in the economy.

So the heritage of those religious usury laws was that, in terms of the interest rate that could be charged, we're talking five or six percent maximum.

And really, it was about 1833 that these limitations were first repealed.

And so, it's from really the mid-19th century onwards that banks become much more involved in terms of financing industrial activity in the economy.

More from Victoria Bateman in a a moment.

You might have noticed that interest rates go up and down, and whenever they go up and down, the Bank of England seems to be involved.

Richard Davis, where is the Bank of England?

Is it a physical place?

Yes, it is a physical place.

I worked there, spent most of my 20s there.

It's on Thread Needle Street in the city of London.

It's a good name.

Yeah, it's a big building.

I'm sort of imagining it's full of kind of gnomes, or maybe there's smaug there on top of a pile of gold.

Central bank architecture is very interesting.

It is like a fortress.

There are no windows at the ground level and that's because it houses in its basement the country's store of gold and actually lots of other financial institutions store of gold.

So it's a bit of a garrison kind of thing.

Yeah.

But it's not really about the gold.

I don't think it's.

No, it's not about the gold anymore.

So the Bank of England is the bank that the high street banks bank with.

So if the high street banks bank with the Bank of England, it should be a tongue twister, but it isn't quite.

Is that then how the Bank of England influences mortgage rates?

Talk us through because

we hear that the Bank of England has put up interest rates, and then not immediately, but pretty soon,

if you've got a mortgage, you get a letter from your mortgage provider that says your interest rates are going up.

So, how are those two things connected?

Exactly that.

So, the best way to understand the Bank of England, I think, is to completely forget about banking and think of a green grocer.

So, if a green grocer faces the price of fruit and veg going up, then they're likely to put their prices up.

And if the price of fruit and veg go down, the wholesale price go down, they'll put their prices down.

So I've got my local green grocer, I go there to buy apples, and one day the apples are more expensive.

And I say, why are the apples more expensive?

And she says, well, I bought the apples from, you know, the apple company or the orchard or whatever.

and they're charging more for apples now.

So I'm charging you more for apples.

The Bank of England is the wholesale supplier of money.

So in practice, what happens is the banks that we all use, the High Street banks from Lloyd's to NatWest to Barclays,

they all at the end of each day, because of our shopping habits, let's suppose Barclay's customers do lots and lots of shopping one day and drain down their accounts.

And HSBC's customers do lots of saving on a particular day, don't spend anything.

The balances that banks have at the end of the day, their own balances go up and down and they need to house those somewhere.

And in practice, what they do is they can park money with the Bank of England and get give their money to the Bank of England and they can also borrow money from the Bank of England and it can charge them a cost and that sets the baseline interest rate in the economy and that's why people that have mortgages or are looking at mortgages will see them quoted in terms of bank rate plus some percentage above the bank rate such that as the bank raises its interest rate mortgage rates will mechanically go up when you say the bank raises its interest rates the bank Bank of England is raising its base rate.

Its base rate.

And everybody else,

not necessarily, but a lot of other people will have mortgages that are explicitly linked to the Bank of England base rate.

So the base rate goes up and your mortgage rate goes up.

Maybe not today, maybe not tomorrow, but soon.

And the basic reason for that is that it changes the costs of the high street banks, of Lloyds, of Barclays and so on, that are making those loans.

And after the mini budget was announced at the end of September 2022, mortgage rates suddenly rose.

So was that just because the Bank of England raised the base rate?

There's something else, and that's the fact that the high street banks don't only get money from the Bank of England.

Typically, we as mortgagers and people that demand cash want more than the deposits are put in.

And the banks, the high street banks, fill that gap themselves by issuing debt, issuing bonds.

That means they go into international markets and say, can we borrow from you?

We'll pay you back at a certain date and a certain interest rate.

So they face another interest rate, which is the interest rate on their bonds.

That interest rate is going to be very closely related to the interest rate that the governments face.

And that's a second reason that the banks might raise their mortgage rates.

And really importantly, that is not a reason that the Bank of England can control with any great accuracy.

Interesting.

So we've talked about how the Bank of England can influence interest rates.

But what I'm hearing is there are other other forces at play.

Banks are going into international markets, they're borrowing from international markets, and the rate they have to pay is rising, and that's nothing to do with the Bank of England.

Exactly.

So, we've talked about what the Bank of England does now.

How do they get started?

Let's get Victoria Bateman to give us some history.

By 1694,

Britain's about to rage another expensive war with France and so needs a huge amount of money, £1.2 million

ideally.

So how does it fund this?

Well, William Patterson, who was a Scottish trader and banker, gets together more than a thousand people.

Now, this group spans the whole of society.

You have everyone from shoemakers up to monarchs, William and Mary, participate in this scheme.

They promise that they will lend to the government, but they want something big in return.

And what they want in return is a royal charter to establish themselves as the Bank of England.

So here we see the creation of the Bank of England as, in a sense, a bank to the government.

So those original founders of the Bank of England, you know, the royalty, the greengrocers, and the doctors that put together this loan for government, they no longer own the Bank of England.

In 1946, the Bank of England was nationalised.

The Bank of England, having been nationalised, then becomes, in a sense, the Bank of the People.

And so, rather than having private goals in terms of, for example, making money for its shareholders, now its goal becomes helping to keep the economy on an even keel.

So, the Bank of England is not just trying to make money, well, is not in fact trying to make money.

The Bank of England is trying to influence the economy.

And in particular, as we discussed last programme, they're trying to keep inflation at about 2%.

What's the connection?

How does the Bank of England influence inflation by influencing the price of mortgages and the price of other saving and borrowing in the economy?

So let's take the example of somebody with a mortgage.

They have a certain amount that they have to pay each month.

The Bank of England raises its interest rate and the High Street Bank, in response, raises its interest rate by the same amount.

The householder, therefore, at the end of the month, faces a higher mortgage payment.

Their disposable income is going to fall.

And so they're going to be spending less in the shops.

The shops have lower demand and have less confidence and ability to put their prices up.

But the interest rate also affects savers.

So if savers face higher interest rates, rates, they're likely to become even keener as savers, squirrel more of their money away, and they also spend less.

This big idea that we've discussed, whether you spend today or spend tomorrow, is how the Bank of England really aims to influence the economy, to either get people spending or to get people to delay spending.

So what's the connection between spending and inflation?

So when inflation is too low, it wants to raise spending.

It wants people to think, instead of thinking, I'm going to buy a car next year or I'm going to move to a bigger house next year, it wants to bring that forward and wants them to do it this year.

And the reason to do it this year is when you face a lower interest rate.

You can get that cheaper mortgage.

You can get a cheaper deal on your car finance.

You spend today.

The companies have more orders coming through.

The person's selling cars, they've got a certain amount of cars to face.

They've got loads of orders and their prices can rise.

Well, thank you, Richard.

Interest rates are raised when the Bank of England is trying to stop you spending all your money on all the things and if prices are climbing too high.

Interest rates are lowered when they want you to start spending your money on things to help the economy grow.

Hmm.

Help the economy grow?

What does that mean?

What is economic growth?

Well, that's a subject for next time.

Or you can find that episode right now on BBC Sounds.

Understand the Economy was presented by me, Tim Harford.

It was produced by Phoebe Keene and Drew Hindman, and the editor is Claire Fordham.

It was mixed by James Beard.

I'm Ella Ashamahi.

I'm an explorer, stand-up comic, and paleoanthropologist.

And I want to tell you about my new podcast, Why Do We Do That?

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If we weren't programmed to be more risk tolerant, the species wouldn't have survived.

And delving into the surprising science of kissing.

I would never be short of willing subjects to participate in my research.

So if you want to find out why do we do that, head to BBC Sounds to subscribe.

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Lease customer cash can be combined with other public offers, including lease incentive offers.

Lease customer cash cannot be combined with APR or other customer cash offers.

Lease customer cash is not redeemable as cash or cash back option.

Lease customer cash is only available on approved credit.

Not all customers will qualify for credit approval or offer.

Limit one discount per customer per vehicle.

Lease customer cash offer only available in the United States regardless of buyer's residency.

Void reprohibited.

Apply within the lease structure as a capital cost reduction.

Lease customer cash is only available on participating Mazda dealer's current inventory, which is subject to availability.

Offer ends 9:30-2025, and you must take delivery prior to expiration of offer.

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