What does the first interest rate rise since 2007 mean for your finances?

While a hike in interest rates from 0.25% to 0.5% might not seem like a momentous event, it is the first increase by the Bank of England in over a decade and for many investors it will be the only rise they have ever experienced.

Although this is unlikely to signal a rapid increase in interest rates in the near future, investors attempting to squeeze the pips out of their portfolios in a low return world will be looking closely at how this small change could affect their personal finances.

Savings

In theory a base rate rise should be good news for cash savers but it remains to be seen whether banks and building societies actually pass the increase on to savers. This is by no means guaranteed so people with savings accounts should hunt around for the best deals following the rate hike.

Unfortunately any increases are likely to be small and with inflation running at 3%, nearly all savings held in cash are losing ground in real terms.

It is also unlikely that today’s increase signals the start of a rapid rise in interest rates. In reality the cut from 0.5% to 0.25% was only ever intended to be an emergency measure after the EU referendum, so today’s announcement is simply returning us back to where we were before that particular market shock.

Anyone who wants their savings to work harder for them will need to consider moving up the risk scale into equity investments. The FTSE 100 is currently yielding around 4% this year, significantly more than you can find on any savings account. For that equation to shift in a meaningful way interest rates would need to rise much higher than they are today (or dividend yields plummet much lower).

Investments

This very gentle tightening of monetary policy is unlikely to spook markets too much, although investors need to focus on three different arenas:

• Sterling. The pound actually fell on the news against the dollar from $1.3220 to $1.3115. On a trade weighted basis, sterling has still lost 11% since the Brexit vote in June 2016. A relatively weak pound may encourage investors to stick with the “pound down, FTSE 100 up” trade which has dominated since the referendum, and only a rapid-fire round of rate hikes is likely to take sterling markedly higher. If the pound does reclaim some of the lost ground, this could help retailers (owing to lower import costs, lower inflation and improved consumer spending power) and also focus attention on other downtrodden domestic sectors like real estate investment trusts, which have been ignored in favour of dollar earners, exporters and overseas asset plays like the engineers, miners and forestry and paper stocks.
• Bonds. Whether you are investing in Government or corporate bonds, you face three key risks: credit risk, inflation risk and interest rate risk – and rising rates are generally bad news for bonds. Bond prices can go up (when yields and interest rates fall) but they can go down (when yields and interest rates rise). This is less of an issue if you buy an individual bond, hold it to maturity and all goes well. But it is a big issue for bond funds, whether they are active or passive, as they do not mature. This means the fund’s value could fall - and do so by an amount which more than offsets the yield they offer, especially if interest rates start to move higher faster than the market currently thinks.
• Stocks. The FTSE 100 took the announcement in its stride, adding to few points to a gain it had already made in early trading. In general, interest rate increases do make life harder for stock markets. This is because increased rates on cash and higher yields on bonds mean investors can get improved returns here so they become less inclined to take the risk associated with shares.

However, this increase is small and the strength of the UK economy remains the big question this time around. Growth looks stuck in the 2% range and if the Bank of England thinks this number merits a rate rise then that does not necessarily say that much for the UK economy, if such mediocre progress is the new normal.

If growth remains subdued and interest rates continue to trundle on at 0.5% then the strategies which have done well in the past few years – momentum and income – could keep working well.

But if the Bank of England is on to something and inflation is accelerating, then those strategies could fall by the wayside. Superior inflation protection comes from value strategies and cyclical stocks – real estate and oils for example – along with miners, commodities and plays on real ‘stuff’ like property and gold and also index-linked bonds.

Pensions

Rising interest rates could provide a welcome boost for savers. As returns on cash rise (albeit marginally), we could see demand for 10-year gilts – long-term debt instruments issued by the UK Government – fall back. This would likely push the price of gilts down and thus force the yield on gilts up.

Because insurance companies use gilt yields to price annuity business, this could translate into an upward tick in annuity rates.

However, average annuity rates have been steadily climbing from historic lows in the past 12 months, with a £100,000 pot now buying a healthy 65 year-old a level guaranteed income of around £5,461 a year*.

It is possible the market has already priced in a base rate hike – if this is the case annuity rates are unlikely to flinch following today’s announcement.

*Source: Money Advice Service calculator

Mortgages

Anyone who locked into a fixed-rate mortgage will be sitting pretty after today’s announcement. But 43% of homeowners are on variable or tracker mortgages where the amount you repay shifts with the base rate, according to the Bank of England.

If this is you, it’s worth factoring a small increase in monthly repayments into your financial planning. Based on a £150,000 mortgage loan with an average monthly repayment of £679.74, a 0.25 percentage point rise in the mortgage rate would increase the monthly repayment by £19.15** - just shy of £230 a year.

If the Bank embarked on a series of rate hikes the effect would be more significant. A move to a base rate of 2%, for example, would leave the same person paying an extra £161.69 a month, or almost £2,000 a year.

**Source: Halifax

Tom Selby, AJ Bell Senior Analyst