What Is an Interest Rate? Who Sets It, and Why It Moves Your Money

A car rents by the day. An apartment rents by the month. Money rents by the year, and the rent is called an interest rate. It's a percentage of the amount borrowed, and somebody pays it to somebody else.

One committee sets one of those prices. Every other price in finance is quoted off it. Your savings, a mortgage, a company's debt, a bond, a share.

The price of renting money

An interest rate is the price of borrowing money for a year. Two things make it a price rather than a fee.

It's a percentage, so it scales with how much you borrow. And it's per year, so it scales with how long you keep it.

Every rate has two sides. Somebody pays it and somebody receives it, and there's no third party in the room.

You're already on both sides. A savings account is you lending money to a bank. A mortgage, a car loan or a card balance is the bank lending to you.

Say you've got $10,000 in savings. It's a round number picked to be easy, not a claim about anyone's account. At the rate an ordinary savings account paid in 2025, 0.40%, the bank pays you $40.00 over the year.

Meanwhile the balance on the card in your pocket is charging 21.22%. Same country, same year, same kind of number. You're the lender in one and the borrower in the other.

So one rate moving is never simply good or bad news for you. It's good news for one side of you and bad news for the other, and which side wins depends on what you owe and what you hold.

Who sets it, and who doesn't

A committee at the central bank meets a handful of times a year and picks one number. That's it. One number.

The number is what banks pay to borrow from each other overnight. It goes by a few names. Policy rate, base rate, or the rate on the front of the news that evening.

Here's what that committee does not set. Your mortgage rate. Your savings rate. What your credit card charges you. What a company pays to borrow. None of those is theirs to decide.

Every rate you're actually quoted is that base plus a margin, and the margin belongs to whoever's lending. It covers two things: the chance they don't get paid back, and their profit.

Look at the width of it. In 2025 the base averaged 4.21%. A savings account paid 0.40%, which is 3.81 points below. A credit card charged 21.22%, which is 17.01 points above. One base rate, 20.82 points between the two people using it.

The order of the three borrowing rungs is the order of the risk. A large company borrows most cheaply, at 1.79 points over the base. It owns things, it publishes audited accounts, and it has a reputation to keep.

A home buyer pays 2.39 points over the base, and the house is the lender's security if the payments stop. A card charges 17.01 points over, because nothing at all backs it except your promise to pay.

The savings rung is the one pointing the other way. Banks pay savers below the base rate, and that gap is a large part of how a bank makes money.

Every country runs its own version of this, with its own committee and its own calendar.

The Federal Reserve, the European Central Bank, the Bank of England and the Reserve Bank of Australia each set a base rate for their own economy. None of them has any say over the others.

The ladder above is measured on published US rates, because that's where all five series print a full-year average for the same period. The shape holds everywhere. The exact margins don't, and neither does the base.

Why it moves

The committee isn't trying to be kind to savers or hard on borrowers. It's aiming at one thing, and that thing is inflation.

Treat the rate as a brake pedal on spending. Push it up and borrowing costs more, so people and businesses borrow less and buy less. Prices then climb more slowly. Ease it down and the whole thing runs the other way.

Most rich countries publish the number they're aiming at, in plain words, on their own websites. The Federal Reserve, the European Central Bank and the Bank of England all target 2% inflation.

The Reserve Bank of Australia is the odd one out. It publishes a band of 2% to 3% and says policy aims at the midpoint, 2.5%.

That's the entire brief. Inflation running above target usually means the rate goes up. Inflation below it usually means the rate comes down.

Now notice who isn't in that brief. Nobody on the committee is thinking about your portfolio. Your fund's return isn't a target, an input, or something they've been asked to protect.

So the decision isn't aimed at you, and it reaches you anyway. That's worth remembering on the days a rate headline is written as though it were personal.

That 2% is a policy choice, by the way, and not a law of nature. What inflation actually is, how it gets measured and what it does to money sitting still, has its own article. It's linked at the end.

The chain from one number to your money

Reading that the base rate moved is one thing. Watching what moves with it is another.

So move it yourself. One slider, four read-outs, and they all answer to it.

Push the base up and every borrower on the panel pays more. Push it up far enough and your savings start earning too. Those look like two levers fighting each other. They're one lever, seen from two sides.

The four sizes are round examples chosen to be legible, not figures from any source. What's real is the arithmetic and the margins, and both are sourced at the end of the page.

Why every asset reprices when the rate moves

Somebody promises you $100. You'll get it in ten years. What's that promise worth to you today?

Less than $100, obviously. But how much less? The interest rate answers it exactly.

If money grows at 2% a year, then $82.03 today turns into $100 in ten years. So the promise and $82.03 are the same deal. That's what it's worth.

Now make the rate 6%. Money grows faster, so you need less of it to reach $100. Today you'd only need $55.84.

Nothing about the promise changed. Same amount, same date, same person promising it. One number moved somewhere else, and the promise is worth less.

Here's why that matters far beyond one promise. Everything you can buy is a claim on money that hasn't arrived yet.

• A bond is a schedule of payments on fixed dates. The dates are printed on it.
• A share is a claim on profits the company hasn't earned yet, stretching out indefinitely.
• A house is decades of rent you won't have to pay, plus whatever it's worth when you sell.

Put a price on any of those and you're doing the arithmetic above. So when the rate changes, every price changes with it. Three consequences follow.

Bonds fall when rates rise. A bond's payments are fixed and written down, so they can't grow to keep up. Discount those same payments at a higher rate and they're worth less today, and the price on the screen drops to match.

The companies whose profits sit furthest out fall hardest. A business earning steadily today has most of its value arriving soon. A business that won't earn much for another ten years has all of its value out where the discounting bites deepest.

Houses reprice too, through the payment a buyer can manage. Take the example loan from the dial above, $250,000 repaid over 25 years. Add the mortgage margin to the 2021 base and you get 2.47%, which is $1,118 a month. Add it to the 2023 base and you get 7.41%, which is $1,833.

None of that needs anybody to panic, and none of it needs a single opinion to change about a single company. The arithmetic changed, so the prices changed.

The rate you're quoted vs the rate you get

The number in the advert is almost never the number you end up with. Two separate things get in the way, and they're easy to mix up.

The first gap: inflation

Prices are moving while your money sits there. The rate on the statement is the nominal rate. What your money can actually buy at the end of the year is the real rate.

Almost everyone works it out by subtracting, and subtracting is wrong. Earn 5% in a year when prices rise 3% and you're 1.94% better off. Not 2%.

The right form divides. Take one plus the rate, divide by one plus inflation, then subtract one. At 5% and 3% that's 1.05 divided by 1.03.

The reason is that your interest gets spent at next year's prices too. Subtracting only takes inflation off the money you started with, and forgets the interest. The error always flatters, and it grows as the rates get bigger.

Real rates go below zero, and they often have. A savings account paying 0.40% in a year when prices rise 2% has a real rate of −1.57%. The balance goes up every year and buys less every year.

The second gap: compounding

The second gap is about timing rather than prices. A rate paid once at the end of the year and the same rate paid monthly aren't the same deal.

January's interest sits in the account for the other eleven months, earning interest of its own. Every month after it does the same.

That's APR against APY. APR is the quoted rate. APY is what a year of it is actually worth once the interest compounds. 5% compounded monthly works out to 5.1162%.

The same effect runs against you on debt, and it's bigger there. A card at 21.22% that compounds daily costs 23.63% over a year.

Deposits tend to get advertised as APY and loans as APR. That isn't a coincidence. APY is the bigger number of the two, so each side quotes whichever one flatters it.

Why interest earning interest matters so much over long stretches has its own article, linked at the end. So does inflation.

Rates and your portfolio

Three consequences, one paragraph each, because each one is somebody else's article.

Bonds you already hold fall in price when rates rise, for the discounting reason above. How far they fall depends on how long you wait for their payments, and that sensitivity is called duration. It has its own article.

Cash pays whatever the base rate allows, minus the bank's cut. At the 2025 base of 4.21%, an ordinary savings account paid 0.40%. Whether that's a gain at all is the inflation question, and inflation has its own article too.

Shares get hit twice. A higher base raises the return you could have had for taking almost no risk, and it cuts what distant profits are worth today. What that does to a mix you actually hold belongs to the article on building a portfolio.

What history actually looks like

One question gets asked about interest rates more than any other. Are they high?

You can't answer it without picking a window first, and the window does all the work.

That line is the US federal funds rate, averaged by calendar year from 1955 to 2025. It's one country's policy rate and nobody else's. If you live somewhere else, your own central bank's line is a different shape, and this one says nothing about it.

The high is 16.38%, in 1981. The low is 0.08%, in 2021. Both were somebody's normal at the time.

The stretch worth staring at is 2009 to 2015. That's seven straight years, and the annual average never once got above 0.18%. Money was very close to free for the whole of it.

It's tempting to call that the flat decade, and it wasn't one. The base climbed back to 2.16% by 2019 before falling to the floor again. Two separate spells near zero, with a real climb in between them.

Then came 2022 and 2023. The annual average went from 0.08% in 2021 to 5.02% in 2023. Anyone who had only ever borrowed in the flat years had never seen a number like it.

Somebody who started paying attention in 2015 learned that money is basically free. Somebody who started in 1981 learned that it costs 16.38%. Both were reading a real series, and neither was reading all of it.

So a rate on its own is neither high nor low. It's a level, and it only becomes high or low once you say what you're comparing it against.

Why a cut isn't automatically good news

Rate cuts get reported like a present. Cheaper mortgages, cheaper company debt, and the discounting from earlier running in your favour.

So look at when cuts actually happen.

The US base fell from 5.02% in 2007 to 0.16% in 2009. It fell from 2.16% in 2019 to 0.38% in 2020. One of those falls is the financial crisis. The other is the pandemic.

Committees cut because they think the economy needs the help. The cut is the response. Whatever prompted it has usually already reached your money.

That's why a cut and a falling market often land in the same week. The cut isn't causing the fall. It's answering it.

This article makes no guess about where rates go next, and it doesn't call today's level high or low. Both of those are opinions dressed up as analysis, and neither one belongs in a definition.

Markets do watch one thing closely here. It's the whole set of rates at once, from overnight lending out to government debt that matures decades away. The shape they make together is called the yield curve, and it gets its own article.