4.2.1 Types of interest rate
Interest rates can be set in a number of ways.
- A variable rate, which can move upwards or downwards during the life of the loan. In the UK variable rates usually move in tandem with movements in the official rate of interest. Some products (called ‘trackers’) are specifically linked to official Bank of England rates.
- A fixed rate where the rate is determined at the start of the loan and remains unaltered throughout the fixed rate term. The rate will be based on what the lender has to pay for fixed rate funds of the same term.
- A capped rate where the rate cannot rise above a defined maximum (the ‘cap’), but below this ‘cap’ it can move in tandem with movements of official interest rates. A variation to a capped rate loan is a ‘collared’ rate loan where rates can move in line with official rates but cannot go either above a defined maximum (the ‘cap’) or below a defined minimum (the ‘floor’). Such products usually require the payment of a fee to the lender at the start of the loan.
Most commonly, personal loans are set at a fixed rate; credit card debt and overdrafts are set at a variable rate; while mortgage lending is split between the three interest rate forms defined above. However, between 2008 and 2013 the volume of ‘capped rate’ mortgage business was very small, with new mortgage lending in the UK being divided between fixed rate and variable rate.
Households with variable rate mortgages are, along with most of those with credit cards and overdrafts, at risk from increases in the official rate of interest made by the Bank of England. As mortgages account for a large proportion of personal debt, it is easy to see why the UK economy can be easily affected by even relatively small movements in interest rates.
You will explore mortgages in detail in Week 6.