What Are Interest Rates – and Why They Matter

Introduction

It is the morning of Wednesday, 16 September 1992. British sterling is pegged to the Deutschemark at DM 2.92 to £1 under the Exchange Rate Mechanism (ERM). Yet the economic ground beneath this system is crumbling. UK inflation is running at triple the German rate, and the base interest rate already stands at 10%.

With hindsight, it is obvious that sterling was under strain. For a select few, it was obvious even then. Chief among them was George Soros, who believed the UK had joined the ERM at far too high a rate - much as John Maynard Keynes had warned in 1925 when Winston Churchill restored the pound to the Gold Standard at its pre-war parity of £1: $4.86.

Acting on this conviction, Soros and other traders took eye-watering short positions against sterling, borrowing marks to sell pounds. Soros alone short-sold $10 billion worth of GBP.

In a desperate bid to stem the pressure, Norman Lamont - then Chancellor of the Exchequer - phoned Soros to announce that the Treasury would borrow $15 billion worth of pounds to counter the sell-off. It made no difference. The base rate was hiked to 12% to attract buyers, but the market ignored it. Sterling kept falling.

By lunchtime, its collapse was all but certain. By 7:00 pm, Lamont announced that Britain would leave the ERM. Rates could have gone higher, but even the hint of triple-digit interest rates was unpaletable to the Bank of England. So, the UK abandoned the mechanism - a day later known to some as Black Wednesday, and to others as Golden Wednesday.

The above may appear tangential, yet it encapsulates within a severe example, the functioning of interest rates. Interest rates are the single most effective policy instrument available to a government, more so than open market operations conducted via the purchase and sale of bonds, more so than government spending which takes at times years for its impact to filter through to consumers. A change in interest rates however is felt by ordinary consumers fast.

Their efficacy is also why they are so discussed within media; any reader of a broadsheet will come across some article almost without fail daily which is speculating on the outcome of the next Fed meeting, or what the Monetary Policy Committee will do next quarter. We are told how investors have priced what they speculate to be the next interest rate into their trades and instruments. The ebbs and flows of interest rates determine the velocity of the economy; they reach their hand into the pockets of individuals to either make a gratuitous gift or involuntary withdrawal.

What are interest rates?

At their core, interest rates are both the cost of borrowing money and the reward for saving it. Consider a simple example using a fictional bank, Big City Bank (BCB). Suppose BCB offers 5% interest on deposits and 10% on loans. An individual who deposits £10,000 for one year, assuming annual interest, will receive £500 and finish with £10,500. A borrower who takes out £10,000 will repay the principal plus £1,000 in interest, totalling £11,000. The bank’s profit is the difference between what it earns from the borrower and what it pays the saver - £11,000 minus £10,500, or £500. This example is simple, even trite, but the basic dynamic is crucial to everything that follows.

Several questions immediately arise: how does BCB decide on those rates? What type of rates are being offered? What other kinds of rates exist? To answer these, we need to place our hypothetical bank within the wider banking hierarchy. BCB is a retail bank, like Lloyds Bank, NatWest or Metro Bank, serving ordinary consumers who can open accounts, make deposits and withdrawals, take out loans, or invest in ISAs. Retail banks sit at the bottom of the hierarchy. A step above them are investment banks, such as Goldman Sachs or J.P. Morgan, which serve companies, institutional investors, and commercial clients. These banks operate on the “sell side” of financial markets, providing capital for others to conduct business, whether through investment, expansion, or complex transactions. Unlike retail banks, they do not offer personal bank accounts - you will not find a Goldman Sachs debit card or a J.P. Morgan current account.

At the top of the hierarchy are central banks, such as the Bank of England or the Federal Reserve in the United States. Their responsibilities vary by jurisdiction, but in the UK the Bank of England is charged with setting monetary policy, and specifically with determining the base interest rate - the rate that ultimately anchors all others. Within the Bank, the Monetary Policy Committee (MPC) meets eight times a year, roughly every six weeks, to vote on whether to raise, cut, or maintain this base rate.

When the base rate moves, it sets off a chain reaction. Investment banks, which hold deposits with the central bank, adjust the rates at which they lend to each other (historically known as the London Interbank Offered Rate, or LIBOR) and to retail banks. Retail banks, in turn, must adjust their own rates to remain profitable - they cannot pay savers more than they earn from borrowing, nor charge borrowers far less than their own cost of funding. As a result, changes at the central bank level filter down through the system until they affect the savings and lending rates that reach individual consumers.

Returning to our earlier example of BCB, suppose a rate cut leaves deposit rates at 1% and loan rates at 2%. A saver who deposits £10,000 for a year would now receive only £100 in interest, finishing with £10,100 - a £400 reduction from before. A borrower taking £10,000 would now repay just £200 in interest, finishing with a liability of £10,200 - £800 less than before. This, all else equal and assuming an ordinary propensity to invest and consume withing individuals, will lead to lower levels of saving as the reward for depositing, and thereby foregoing use of, £10,000 for a year is only £100. Similarly, the incentive for both individuals and businesses to borrow money is increased, as the interest on the same loan has fallen from £1000, to £200 which makes perceived capacity to repay substantively higher for all. Taken together, there will be less deposits and more borrowing, and thus more money within the circular flow of the economy being spent, as opposed to simply deposited within a bank. All in all, this demonstrates how a single decision at the central bank level can reshape the behaviour of banks, borrowers, and savers throughout the economy.

Types of interest rates

Above we have considered a simple, fixed annual interest rate. The saver was paid their rate after a year, and the payment did not vary with any other economic variable. There are, however, several types of rates and they can be categorised in several ways also. The first is the highest level of categorisation. The above example was a nominal interest rate, however, economically, the more relevant consideration for individuals is the real interest rate. The real interest rate is the nominal interest rate accounting for inflation. Look again at the saver in our first BCB example: with a deposit of £10,000 at 5% p.a., the nominal return was £500 leaving a closing balance of £10,500. However, if over that same year inflation was 3%, then the real interest rate was only 2%. To see the actual implication of this, assume the saver only buys apples, all of which are £1 each. At the start of the year, the saver could buy £10,000/£1, or 10,000 apples, had inflation been 0% they would have been able to buy £10,500/£1, or 10,500 apples. However, with inflation at 3%, apples have increased in price from £1 to £1.03, meaning that our saver can now only purchase £10,500/£1.03, or roughly 10,200 apples – a 2% increase. Real interest rates thus must be considered when assessing the potential returns on a given deposit as a lower nominal rate (say 2%) in a nation with lower inflation (say 0.5%), will be higher than those realised from a high nominal rate (suppose 10%), in a nation with high inflation (say 9%).

The next classification here relevant are fixed and variable rates. Above we have considered fixed rates, where the rate paid upon maturity is pre-determined between the bank and saver/ borrower. A variable rate however will change upon the occurrence of certain prescribed events. For example, a rate could be offered on deposits by a Retail bank, which is LIBOR + 0.25% (or “25 basis points” in market parlance). Accordingly, where the LIBOR moves, the rate received on deposits will move in lock step: an increase in LIBOR from 3% to 4%, will increase the interest received on the deposit from 3.25% to 4.25% and vice versa with a LIBOR decline. Accordingly, the saver does not know in any meaningful way what the future value of their deposit will be. If LIBOR moves and stays at 8% for the whole year, then they receive £825 in interest and leave the year with a balance of £10,825, however a decline to 1% would leave the closing balance at only £10,125. Clearly there is an inherent trade off with accepting variable rate interest: there is a potential for higher returns than that of a fixed rate, but equally there is the chance of a lower rate. This relative certainty is what will draw most individuals to fixed rate savings accounts.

A further and important classification is that of simple and compounding interest rates. Above we have looked at simple interest rates, calculated annually. Accordingly, the interest was calculated by multiplying the initial deposit by the offered rate, or:

FBs = P (1 + rt),

where FBs is the final balance of a simple interest rate, P is the principal, r is the annual interest rate, and t the time in years. Compounding interest however differs, as at every compounding period, the interest due and payable, is added to the principal and included in the next interest calculation. Accordingly, compound interest is calculated as follows:

FBc = P (1 + r / n)^{^nt}

Where FBc is the final balance of a compound interest rate, P is the principal, r the annual nominal interest rate, n the number of times the interest is compounded per year, t the number of years. A worked example shows the substantial difference compounding interest has. We return to BCB, but this time we will assume the 5% interest compounds quarterly, thus n = 4 and we will maintain a single year deposit, thus t = 1. FBc is thus:

FBc = £10,000 (1 + 0.05 / 4)^^{4 x 1}

FBc = £10,509.45

That is not a dramatic jump from the simple rate, but with both greater deposit durations, or more frequent compounding periods, or both, the value of FBc grows exponentially. Firstly, let the deposit remain for ten years, hence t = 10. Secondly, we adjust the compounding period to be monthly. Lastly, we show a monthly compounding over the extended deposit duration.

FBc = £10,000 (1 + 0.05 / 4)^^{4 x 10}

FBc = £16,436.19

FBc = £10,000 (1 + 0.05 / 12)^^{12 x 1}

FBc = £10,511.62

FBc = £10,000 (1 + 0.05 / 12)^^{12 x 10}

FBc = £16,470.09

Over the same period, the simple interest rate would have, for a 10-year deposit, become merely:

FBs = £10,000 (1 + 0.05 x 10)

FBs = £15,000

Which is simply the £500 interest added to the principal 10 years in a row, and ultimately £1288.95 less than what was earned under compound interest over the same period, compounding annually. Hopefully this impresses upon the reader the variability in the term interest rate and the various forms they can take.

Why do interest rates matter for everyday life?

By now, the reader will have understood the primary mechanism through which interest rates affect daily life: borrowing and saving incentives. We have seen how adjustments by a central bank ripple through the banking system, ultimately influencing consumer behaviour, business decision-making, and long-term economic planning. However, there are additional, often overlooked effects that can be particularly impactful.

Perhaps the most immediate and noticeable impact is on those with variable-rate mortgages. Just like other loans, mortgages can be either fixed or variable. With a variable-rate mortgage, the interest repaid each month depends on broader economic conditions. In the United Kingdom, most variable mortgages fall into one of two types:

• Tracker mortgages, which move automatically with the Bank of England base rate (for example, “base rate + 1%”).

• Standard Variable Rate (SVR) mortgages, where the lender sets the rate, typically adjusting it in line with the base rate as their funding costs change, influenced by market benchmarks such as the Sterling Overnight Index Average (SONIA) or LIBOR.

• 
  

By contrast, fixed-rate mortgages lock in a rate for a set term, insulating borrowers from base rate changes until the fixed period ends. When the base rate rises, tracker mortgages increase almost immediately, SVRs often follow soon after, and monthly repayments can grow substantially. Conversely, when rates fall, borrowers on variable rates benefit from lower repayments, while fixed-rate borrowers remain unaffected. This inherent variability is why fixed-rate mortgages typically carry a small premium - a slightly higher rate than comparable variable mortgages - reflecting the reduced risk to the borrower.

Interest rates also influence house prices. When rates decline, mortgages become cheaper, making homes more affordable and often pushing prices higher. When rates rise, borrowing costs increase, which can place downward pressure on house prices.

Another prominent way interest rate fluctuations affect individuals is through credit cards. Like mortgages, credit card interest rates can rise or fall, but they often compound frequently, allowing debt to grow rapidly if balances are not repaid in full - essentially the inverse of the compounding example seen with savings.

Why do Interest Rates Matter for Businesses?

Interest rates have a profound influence on businesses, particularly through their effect on stock and bond prices. When interest rates rise, the yield on new bonds increases. Because existing bonds pay a fixed coupon, they become less attractive by comparison, so their market price falls. This reflects the fundamental inverse relationship between interest rates and bond prices: as new bonds offer higher returns, older bonds must trade at a discount to provide investors with a competitive yield.

Stock prices also respond to interest rate movements. Higher rates increase the cost of borrowing for companies, which can reduce expected future profits and cash flows. At the same time, higher rates make safer fixed-income investments like bonds more attractive relative to equities, dampening demand for stocks. Conversely, when interest rates fall, borrowing becomes cheaper, corporate profits often rise, and stocks become relatively more appealing compared with bonds, driving equity prices higher.

Recalling our earlier discussion of borrowing by individuals, the same logic applies to businesses. As interest rates change, so do corporate borrowing costs. Higher rates make borrowing more expensive, which can discourage investment. Without affordable credit, businesses may cut back on research and development, delay expansion, and pursue fewer mergers and acquisitions. Startups may struggle to access capital at viable rates, which can result in fewer new ventures being launched or otherwise promising young companies shutting down prematurely.

Companies carrying high levels of existing debt are especially vulnerable to rising rates, in much the same way that a mortgagor with a variable-rate mortgage is. A sharp rate hike can quickly transform a manageable debt load into an unsustainable one. Because corporate borrowing is often measured in tens or hundreds of millions, even a small percentage increase in rates can raise interest payments by millions of pounds, straining or depleting company capital.

Interest rate movements also affect corporate valuations. At a basic level, companies and the projects they undertake (for example, a horizontal acquisition of a competitor) are valued using discounted cash flow models, which apply the prevailing interest rate to estimate the present value of future profits. The interest rate represents the opportunity cost of tying up capital rather than placing it in a safe interest-bearing account. As interest rates rise, the present value of those future profits falls, reducing the incentive for executives to pursue new projects and often lowering the market valuation of the company itself.

All these impacts must also be considered alongside the legal and contractual implications of rate changes. Many commercial contracts contain floating or variable interest rate clauses, which must be honoured regardless of their financial impact. For example, a company might have a revolving credit facility tied to the Bank of England base rate; if the base rate jumps from 3% to 6%, the company’s interest costs double immediately under the terms of that agreement. Relatedly, some contracts include default interest rates and penalty clauses, which can further escalate liabilities if a company misses a payment. In practice, this means that a sudden rate hike could push a company already under strain into technical default, triggering higher penalty interest and accelerating repayment obligations, further worsening liquidity pressures.

International businesses face an additional layer of complexity: currency movements linked to interest rate changes. For example, when a large sell-off weakened the pound, the Bank of England raised rates to support its value. Higher rates make pound-denominated deposits more attractive relative to foreign currencies, increasing demand for sterling; lower rates have the opposite effect. As a result, multinational companies must ensure they have sufficient liquidity in each currency to meet local obligations. Otherwise, they risk having to convert foreign currency at unfavourable exchange rates simply to cover basic expenses, increasing costs unnecessarily.

In the worst cases, these combined pressures can lead to insolvency. The specific legal processes surrounding insolvency are beyond the scope of this discussion, but in broad terms, it involves liquidating a company’s assets to repay its creditors when it can no longer meet its obligations. Consider a business with a substantial floating-rate loan: a sharp rise in interest rates could render its debt unserviceable, quickly draining capital and pushing it into insolvency if it cannot raise funds to cover the shortfall. The impact rarely stops with the business owners - employees lose their jobs, and suppliers or customers that relied on the now-insolvent company may face severe disruption. For example, a manufacturer might suddenly lose a critical component supplier, halting production and leaving it unable to fulfil existing orders, which could in turn trigger penalty clauses in its own contracts. These effects can rapidly cascade through the wider economy.

Conclusion

By now, the sheer importance of interest rates for everyday life should be clear. We have seen how rate changes by the Bank of England flow through the financial system to shape the incentives for borrowing and saving. They influence the cost of mortgages - particularly variable-rate products such as tracker and SVR mortgages - alter monthly repayments and indirectly drive house prices. We also saw how they affect consumer credit, with rising interest costs on credit cards compounding debt balances quickly when unpaid.

For businesses, we explored how interest rates affect financial markets, pushing bond prices down as yields rise and influencing stock valuations as higher borrowing costs reduce future profits and shift investors toward safer fixed-income assets. We examined how rate rises increase corporate borrowing costs, limiting investment in R&D, expansion, M&A activity, and startup formation. We looked at the heightened vulnerability of heavily indebted companies to sudden rate hikes, the way higher rates reduce the present value of future cash flows (lowering project and company valuations), and the legal and contractual risks posed by floating-rate clauses, default interest, and penalty provisions. We also considered how international firms face currency risks as shifting interest rates alter exchange rates, and how - in the worst cases - these pressures can culminate in insolvency that cascades through supply chains and the wider economy.

Ultimately, interest rates are not just an abstract lever of monetary policy but a central force shaping economic behaviour at every level. They influence the daily financial decisions of households, the strategic planning of corporations, and the stability of markets themselves. Understanding their effects is essential for navigating both personal and business finance in an ever-changing economic environment.

Any enquiries relating to this blog please contact me at: www.linkedin.com/in/jameswbward1