Unless you’ve been on a tropical island somewhere in the south pacific, with no access to the internet (heaven forbid!), you’ve probably been hearing a lot about interest rates lately. Sometimes it seems like interest rates are just something we accept. But what are interest rates, and how do they affect our money? …
Interest, in simple terms, is the price you pay to borrow money from a lending institution. The interest rate is a percentage of the original amount that is loaned, called the principal amount. A loan at 6.5% per annum will naturally cost you less over time then a loan at 8% per annum.
Why are interest rates important?
Interest rates are extremely important to the financial system. In a sense, they dictate the value of money itself. The lower interest rates are, the more likely people are to acquire loans. If interest rates are too high, people will not be able to afford the loan repayments and will be far less likely to borrow. This means less consumer spending, less new business, and far less economic growth. At the same time if credit remains cheap, and there is too much economic growth (see the year 2008 for reference!) it becomes like a runaway train that will eventually crash. High interest rates can curb excessive borrowing or prevent the potential of asset bubbles.
Who sets interest rates and why?
“What’s your interest rate?” might sound like a question for a Love Island contestant but it’s the job of the European Central Bank (ECB) to set interest rates for the Euro area. Setting interest rates appropriately keeps economies on an even keel. By moving interest rates up or down central banks can regulate activity, stimulate growth, and maintain price stability.
Exchange Rate and Global Trade
When a country’s interest rate is high, it becomes more attractive to foreign capital. There is an increase in exchange rates, a stronger currency and exports become more expensive. Lower interest rates make a currency less appealing and exports much cheaper. Currently the world’s strongest currency is the Kuwaiti dinar (KWD). You will get 0.33 Kuwait dinar for one Euro. The world’s weakest currency is the Iranian Rial, where one Euro will get you 45525 rials, and the cost of living is on average 54.5% lower than in the US.
Central banks around the world are raising interest rates to reduce demand and spending…At the same time centrals banks must be careful not to increase interest rates so high that consumers are put off borrowing and spending entirely, thus plunging the economy into recession. It’s like a very high stakes seesaw.
Investor behaviour
When interest rates are low, banks want consumers to spend rather than save, so they do not offer much interest on savings. Bonds also don’t offer great returns when interest rates are low, leading investors to seek out equities. Recently, with interest rates on the rise, there has been a bigger move to bonds from investors.
Rising inflation = rising interest rates
As you’ve probably noticed by the lack of funds in your bank account, we are currently in a time of high inflation. To combat this, central banks around the world are raising interest rates to reduce demand and spending. This brings prices back to affordable levels. At the same time centrals banks must be careful not to increase interest rates so high that consumers are put off borrowing and spending entirely, thus plunging the economy into recession. It’s like a very high stakes seesaw.
Mortgage interest rates
Mortgage interest rates vary from country to country due to factors such as inflation, economic growth, monetary policies, the bond market, and the stability of the housing market within that country. In Nordic countries, interest rates are overall lower due to the financial stability of its borrowers. During April 2023, the average interest rate on new fixed-rate mortgages in Ireland (which is 93% of all new mortgages) was 2.83%. Malta has the lowest average rate in Europe at 1.98% and Latvia has the highest rate of 4.65%. The average three bedroomed house in Dublin is €433,000, a three bedroomed apartment in Riga starts at €50,000.
Interest rates and you
As of May 2023, the ECB has raised interest rates seven times in a row. Borrowers who are on variable interest rates mortgages are feeling a very serious pinch but unfortunately inflation is simply too high and interest rates must be hiked to slow it. If inflation does not recede, we will all be feeling more serious pain as time goes on.