Interest rates explained: what central banks do and how rates affect you

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Interest rates are in the news whenever a central bank meets, and for good reason: they affect what you pay on a mortgage, what you earn on savings and, over time, how fast prices rise. Here is what is going on behind the headlines. This guide explains the mechanics; it is not financial advice.

What an interest rate is

An interest rate is the price of borrowing money. If you borrow, you pay interest to the lender; if you save, the bank pays interest to you, because it is in effect borrowing your money. Rates are usually expressed as a percentage per year.

What a central bank does

Most countries or currency areas have a central bank: the Federal Reserve in the United States, the European Central Bank for the euro area, the Bank of England in the UK and the Bank of Korea in South Korea, for example. One of their main jobs is to keep inflation low and stable. They do this mainly by setting a short-term policy rate (called the base rate, the bank rate or the federal funds target, depending on the country). This influences the rates at which banks lend to each other and, through them, the rates offered to households and businesses. Central banks decide at regular meetings. The US Federal Open Market Committee holds eight scheduled meetings a year, and the Bank of Korea's Monetary Policy Board also meets eight times a year to set its base rate. Many central banks aim for inflation of around 2% over the medium term; both the Federal Reserve and the Bank of Korea use a 2% target.

Why rates go up

When inflation is running above target, a central bank may raise rates. Higher rates make borrowing more expensive and saving more attractive, so people and businesses tend to spend and borrow less. With less demand chasing goods and services, price rises tend to slow. The trade-off is slower economic growth and, potentially, higher unemployment.

Why rates come down

When the economy is weak or inflation is below target, a central bank may cut rates. Cheaper borrowing encourages households to spend and firms to invest, which supports jobs and growth. The risk, if rates stay too low for too long, is that inflation picks up. Policy works with a lag. A change in rates can take many months, often a year or more, to have its full effect, which is why central banks act on forecasts as well as current data.

How rates affect loans

Variable-rate loans and mortgages usually move with the policy rate fairly quickly, so monthly payments can rise or fall.
Fixed-rate loans stay the same until the fixed period ends; the change hits when you refinance or remortgage.
Credit cards and personal loans are generally priced well above the policy rate, but they tend to move in the same direction.
Businesses face the same pressures, which affects decisions to invest or hire.

How rates affect savings

When policy rates rise, banks tend to offer better rates on savings accounts and deposits, though not always by the full amount or straight away. When rates fall, savings rates usually fall too. What matters for savers is the real interest rate: the rate you earn minus inflation. If your savings earn less than inflation, your money buys less over time even though the balance grows.

How rates affect prices and the wider economy

Housing: higher mortgage costs tend to cool house prices and sales; lower rates can push them up.
Exchange rates: higher rates can make a currency more attractive to foreign savers, which can strengthen it and make imports cheaper.
Government borrowing: higher rates make public debt more expensive to service.
Asset prices: shares and bonds often react to expected rate changes, sometimes before the central bank acts.

Why you hear about "expectations"

Markets and lenders look ahead. If people expect rates to rise, fixed mortgage rates and bond yields may rise before the central bank moves. That is why central bank statements and forecasts, not just decisions, move markets.

Where to check current rates

Rates change, so this guide does not quote them. For the latest policy rate, go to the central bank's own website. For loan and savings rates, compare offers directly with lenders and read the terms carefully. Have a question about how a rate change affects your loan or savings? Ask in the comments below and share what you have noticed.