Base Rate

When dealing with any form of lending, be it in the form of a loan or mortgage, it is common to come across the term 'base rate' in reference to the interest rates charged. What is unclear is what exactly this base is, how it is decided upon and how it can affect the cost of borrowing - this guide is intended to clarify things in this regard.

Fist off, the term 'base rate' is in fact a vernacular term used to describe what is correctly called the 'Bank of England repurchase transaction rate'. It's easy to see why this rather long-winded name is shortened, unfortunately it has another shortening just to confuse things, that being the 'Repo rate'. Finally, it is common for it to be referred to simply as the 'interest rate' depending on the context. We will use the 'Base Rate' term from now on to keep things clear, but be aware that lenders will often use other names for it.

The Base Rate is set by the Bank of England (BoE), more specifically this task falls to a special sub-committee of the BoE known as the Monetary Policy Committee. It is the nine members of this group who ultimately have control over the Base Rate, and they have to take into account a wide range of economic data when deciding what levels the interest rate should be set at. Their main aim is to keep inflation of the Consumer Price Index (CPI) running at a level of two percent, a target given to them by the Chancellor of the Exchequer when he gave the control over the Base Rate to the committee back in 1998.

The Base Rate is a powerful tool in controlling the state of the economy, and small variations in it can have a large impact in a number of areas, from consumer spending to house prices and even manufacturing levels. The reason why it can have such an effect is because it directly affects the money in most people's pockets. All lending in this country is based on the Base Rate, that is interest rates are set by the lenders according to the level of this, generally speaking the interest rates on any form of loan will be equal to the base rate, plus the cut that the lender wants to make. (We say cut, because in theory they could invest their capital and receive a rate at least equal to the Base Rate, therefore that value is effectively their operating cost).

With lending rates so closely tied to the Base Rate, when the BoE raises the rate so too do the lenders, while it may not affect personal loans that have an agreed rate for the life of the loan, it will affect most mortgages and new loans, making them more expensive. Conversely, when the Bank lowers the Base Rate, mortgage and new loan costs drop, making credit more affordable.

So how does the Base Rate control the economy? In truth, it is hugely complex, but in simple terms a high Base Rate discourages people from borrowing, and encourages saving, this has the effect of lessening consumer spending. The rules of supply and demand kick in and prices fall, lowering inflation. The opposite occurs when rates fall - borrowing is cheap, savings don't earn much and so spending rises, followed by an increase in inflation.

So there you have it, the Base Rate - to the individual it is simply something that determines to a large degree how much their loan or mortgage will cost them, while to the economy it is a powerful tool for economic control.