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How to manage the impact of rising interest rates on debt

Written by
Sajni Shah
Consumer money expert
9 min read
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When we sign off on a mortgage, take out a loan to pay for a large expense, or even just make a payment on our credit card, we tend to only think about the sticker price itself. What often escapes our mind are the additional costs which come with a purchase – namely, the interest.

Interest is a monetary charge for borrowing money. It’s usually charged as an annual percentage rate on money you’ve borrowed. So not only do you have to pay back the capital you borrowed each month, but also the interest on top (usually calculated as an Annual Percentage Rate).

This can place added financial pressure on a household, at a time when a cost of living crisis is making it tougher than it has been in years to make ends meet. In this short guide, we’ll discuss what’s causing this sudden interest hike, the current state of inflation in the UK, and, most importantly, what you can do to reduce the impact that rising interest rates are having on your existing debt.

The current state of interest rates in the UK

While things are a long way off from the heights of 1971, when interest rates sat at 17%, the current national rate in the UK is a healthy 5.25% – as of August 2023.

And while that’s a significant step up on what those in the 70s experienced, it’s a figure which represents the highest that the rate has been on British shores since 2008. This number, known as the “Bank Rate”, does not determine the interest payment on every loan in the country – but it is used as a guideline for how other loans and debt payments might be charged.

As the Bank Rate continues to climb, so do other forms of interest on loans. Most types of interest rates have risen across the past ten years, leaving people in a much trickier position to pay back what they owe.

Some examples of where other types of loans have drastically risen include:

  • Interest rates on gilts – Now sat just above 4%, having been below 1% in 2020
  • Mortgage rates – These rates peaked at 6% in late 2022, but have fallen to just under 5% in August 2023. They’re still much higher than the 1.5% they sat at in late 2021
  • Business loans – These have spiked in recent months, climbing up to 6% from a low of 2.5% in 2021

Although things might feel a little bleak, UK residents can be buoyed by the fact that they’re far from in the worst position on a global scale. While countries like Switzerland and South Korea boast a 1.75% and 3.5% rate of interest respectively, nations with a worse Bank Rate include the likes of:

  • The US – 5.5%
  • India – 6.5%
  • Russia – 12%
  • Turkey – 17.5%
  • Argentina – 118%

Why are interest rates rising?

While a number of factors determine where you can expect the existing rate of interest to sit at, arguably the most important is national inflation. This is what directly impacts the Bank Rate.

Inflation occurs when the cost of everyday items and goods increases for the average consumer. Every month, The Bank of England (BoE) will check the price of 700 goods which people buy on a regular basis. This figure is compared to previous totals to work out the total percentage of inflation for a period.

The BoE sets a target inflation percentage of 2%. As of the current figures, it sits at 6.8%. That means the Bank Rate is likely to continue rising in order to bring it back closer to the target total.

The BoE will increase the Bank Rate in order to combat and attempt to lower the total cost of inflation. By doing so, they’re trying to entice companies to save more and borrow less – reducing the cost of items for customers, and curbing the rate of inflation in the process.

The higher inflation grows, the higher the Bank Rate needs to be to bring it back down again. And while that increases the amount of interest you get paid into savings accounts, it also increases the amount you have to pay in interest on your loans or mortgages.

What you can do to manage rising interest rates

Thankfully, there are steps which you can take to minimise the impact that rising interest rates have on your repayments. Here are some effective steps to make their effect on your finances a little softer.

  • Try to pay back credit cards in full every month. An oldie but a goldie, one guaranteed way to avoid succumbing to heavy interest on credit card payments is to clear your debt every month. That means paying the total cost of what you’ve spent back in full. This will ensure your interest payments remain at nothing, and negates any potential impact of inflated rates.
  • Pay down debt with the highest interest rates first. If you’re unable to pay off all your bills at once, think about starting with the debt that has the highest rate of interest. As we’ve discussed, rates will vary depending on the type of loan you’ve taken out. Find the debt which has the highest rate of interest, and concentrate your efforts on repaying this first.
  • Have a financial plan in place. For larger payments, where a sudden hike in interest rates are going to hit you hardest, think about making a financial disaster plan. Pre-empt a 2.5%-5% change in interest rates, and work out how much more you’d have to find every month to cover these costs. While the figures might look scary at first, they’ll give you the chance to prepare and adjust your budget accordingly.
  • Understand every inch of your budget. In order to make the most out of your financial plan, you’ll need to get to grips with every expense coming in and going out of your accounts. The better you understand where your money is going, the easier it’ll be to cut costs and find the extra cash you might need to account for a rise in rates. Think about where you could already be saving money, and try to reduce your monthly outgoings ahead of time.
  • Overpay when rates are lower. If rates happen to dip, a big hike is expected, or you just find that the current repayment plan you’re on isn't hurting your wallet too much, consider making higher monthly payments than necessary. While it’s less money in your pocket in the short term, it will reduce the total debt you owe. The net result of this is that you’ll be less heavily impacted in the event of a sudden rise in rates in the future.
  • Have an emergency fund ready to go. If you’re really worried about needing to find extra money in a pinch, having an emergency fund for this kind of situation is your best failsafe. This is a pot you can regularly contribute to when you feel comfortable, which in turn will help you out when you find that you need extra cash. Put a small amount aside every month, and draw on it when you feel you need to – not for luxury payments.

How will rising interest rates affect my loan?

How an interest rate rise affects your existing loan will depend on two factors:

  1. The exact type of loan it is
  2. Whether you have a fixed or variable rate of interest

Different loans will be impacted to different extents by the rising interest rates dictated by the UK’s Bank Rate. Perhaps the most affected are mortgages, where the base rate has a big impact on how much lenders charge in interest.

Those with a fixed rate won’t notice a difference for the period that their loan rate is fixed for. But for those on variable rates, the increase means higher costs month-on-month. In the time between June 2022 and August 2023 alone, a £150,000 mortgage would have shot up from £776 to £1,096 a month in repayments – an increase of £3,840 across a calendar year.

It’s for this reason that households need to be vigilant with spending, and have a plan in place to brace for a sudden hike to a mortgage or other form of private loan.

A smart approach to take would be to work out your repayments at a much higher rate than your existing one. Factor this into a monthly budget, and try to have enough spare to soften the blow of a hit should rates continue to rise.

How long will inflation continue in the UK?

Just as with most financial factors, it’s impossible to concretely set a date on when interest rates and inflation are expected to level out and, hopefully, return to some sort of normality. But the signs are already positive.

Inflation sat as high as 11% in October of 2022. By June of 2023 that had fallen to just 8%, and, as we’ve discussed, the rate now sits around 6.8% as of August 2023.

The BoE expects inflation to fall to 5% by the end of 2023. And while that might sound like good news for the potential halting of rising interest rates, UK citizens should expect to see continued changes all the way through until early 2025.

This is the point at which the BoE predicts that inflation will reach their target of just 2%. As such, it’s likely that the Bank Rate will continue to rise from now until then to account for that (albeit at a slightly slower rate than the current 0.25% a month).

Sajni Shah - Consumer expert on utilities and money

Sajni is passionate about building products, allowing Compare the Market to help you make great financial decisions. She keeps track of the latest trends and evolving markets to find new ways to help you save money.

Learn more about Sajni