What it means
The bank rate goes by several names depending on the country, including base rate, policy rate and discount rate. Whatever the label, it is the price of central bank money and the reference point for the rest of the market.
Commercial lending is then quoted as the bank rate plus a margin that reflects the individual borrower's risk. Central banks move the rate to manage inflation and economic activity.
Raising it makes borrowing dearer, cools spending and investment, and tends to bring inflation down over time. Cutting it does the reverse, which is why rate decisions and the language around them are watched so closely.
For a business, the transmission is direct and quick. Overdrafts, revolving facilities and most variable-rate term loans reprice automatically when the bank rate changes, often within a single billing cycle.
Fixed-rate debt is insulated until it matures, at which point the new market rate applies in full. The effect is not confined to interest bills.
Higher rates raise the discount rate used in investment appraisal, so a project that cleared the bar at 6% may fail at 9%, and capital budgets shrink accordingly. Higher rates also tend to strengthen the currency, which helps importers and squeezes exporters.
Sensible planning means knowing your exposure before the next decision rather than after it. Work out how much of your debt is floating, model a one percentage point move in each direction, and decide in advance whether fixing part of the balance or buying a hedge is worth the cost.
In practice
Real-world examples.
Example
A property investor with four buy-to-let mortgages on variable rates sees monthly payments rise by $1,400 in total after two consecutive rate increases. Rental income is fixed until the tenancies renew, so the margin is squeezed for nine months.
Example
A packaging manufacturer with a $5,000,000 term loan decides to fix 60% of the balance and leave the rest floating, accepting a slightly higher starting rate in exchange for a predictable interest bill through a capital investment programme.
Example
A retailer sitting on $900,000 of cash finds its deposit rate rising alongside the bank rate. Interest income becomes a visible line in the management accounts for the first time in years and offsets part of a weaker gross margin.
Formula
Calculation
Interest cost on floating-rate debt = principal x (bank rate + lender's margin).
A company has a $1,200,000 revolving facility drawn in full, priced at the bank rate plus a margin of 2.5%. With the bank rate at 4.25%, the all-in rate is 4.25% + 2.5% = 6.75%, so annual interest is $1,200,000 x 6.75% = $81,000. If the central bank raises the bank rate to 5.25%, the all-in rate becomes 7.75% and annual interest rises to $1,200,000 x 7.75% = $93,000. The increase is $93,000 - $81,000 = $12,000 a year, or $1,000 a month, from a single one percentage point move.Case study
Seen in the real world.
Marlow Kitchens is an entirely fictional company used to illustrate rate exposure. It carried $3,000,000 of floating-rate debt, all priced against the bank rate plus 2%, and had never modelled what a rate rise would do to its covenant headroom.
Over eighteen illustrative months the bank rate rose by two percentage points. Interest expense increased by $3,000,000 x 2% = $60,000 a year, which by itself was manageable. The problem was the interest cover covenant, which required earnings to be at least four times interest: with interest rising from $150,000 to $210,000, the required earnings threshold moved from $600,000 to $840,000, and trading had not improved by anywhere near that amount.
The illustrative lesson is that rate risk shows up in covenants before it shows up in the bank account. Modelling a rate move against covenant tests, not just against the interest line, is what turns a forecast into a warning.
Watch out
Common mistakes.
- Assuming the rate you pay moves exactly with the bank rate. Lenders can also change their margin at renewal, so the all-in cost may rise by more than the headline move.
- Looking only at the interest expense when rates rise. Covenant tests, investment appraisal hurdles and customer demand all shift as well.
- Fixing the entire debt balance at the top of a rate cycle. Break costs on fixed-rate debt can be substantial if rates then fall and you want to refinance.
Questions
People also ask.
What is the difference between the bank rate and the rate my business actually pays?
Your rate is the bank rate plus a margin set by your credit risk, security and relationship, so a stronger balance sheet narrows the gap.
How quickly does a change reach my loan?
Floating-rate facilities usually reprice within one billing period, while fixed-rate debt is unaffected until maturity or refinancing.
Does a higher bank rate help a business with cash?
Yes, deposit rates generally follow the policy rate upwards, so a cash-rich company earns more, though usually with a lag and a smaller move than borrowers face.
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