Interest rates are the price of money. In other words, the cost of borrowing money or the reward for saving it. They are calculated as a percentage of the amount borrowed, invested or deposited.

• When you borrow money (like a loan or mortgage), the interest rate tells you how much extra you’ll have to pay back on top of the money you borrowed (known as ‘the principal’).
• When you save or invest money, the interest rate determines how much extra money you’ll earn over time.

The official interest rate is set by countries’ central banks to control price levels. In the eurozone it’s the European Central Bank (ECB), and in the US it’s the Federal Reserve. This rate is what commercial banks pay to borrow money from central banks, which are the ones that ultimately control the amount of money in circulation.

Banks use the official interest rate as the reference rate for their products, such as mortgages or deposits. But the specific interest rate applied to each product will depend on the term, risk, collateral, type of transaction, the customer's credit profile, and other factors.

Monetary policy is a set of actions central banks take to achieve their main goal, which in the case of Europe is price stability and, in the United States, employment as well. They use a set of instruments to control money supply and credit conditions, with interest rates being the most important. 

By adjusting interest rates, central banks aim to influence inflation (the rate at which the overall prices for goods and services change over time), in order to achieve stable, long-term economic growth. 

Controlling inflation is important because when prices rise too quickly, it reduces people's purchasing power, discourages savings (as consumers prefer to avoid delaying decisions if they believe prices will rise even more in the future) and, as a result, causes investment to dwindle and economic growth to slow in the long run. Moreover, higher prices make us less competitive compared to other countries, hampering exports and increasing imports.

On the other hand, deflation (continued price declines) can severely damage economic growth and employment, as it can lead to a delay in consumption decisions in the hope that prices will continue to fall, causing economic activity to decline.

So, the best scenario is to have low and stable inflation over time.

By raising and lowering interest rates, central banks can influence consumption and investment decisions, which in turn influences the supply and demand of goods and services, helping to adjust prices and, consequently, inflation.

Changes in interest rates affect the prices of goods and services and economic activity in general. 

Against this backdrop, lower interest rates (which are part of an expansionary monetary policy) encourage higher borrowing and investment, stimulating demand for goods and services and thus economic activity. 

On the other hand, higher interest rates (or restrictive monetary policy), help curb spending and borrowing, thereby reducing inflation and cooling growth.

The transmission of monetary policy to the economy is not immediate and it is difficult to pinpoint the exact impact that rate changes will have on inflation and economic activity, as many interrelated factors are affected. For example:

• Lending and deposit rates applied by banks: As we have seen, these are directly affected by changes in central banks' official interest rates.
• Expectations: People’s expectations on how interest rates might pan out in the future also influence spending and investment decisions. Moreover, these expectations set the long-term rate levels that are used as a benchmark for some products such as fixed-rate mortgages.
• Wages: Wage increases are highly relevant to the effectiveness of monetary policy. If price increases are passed on to wages, the power of an interest rate hike to control inflation will be reduced.
• Exchange rates: A rise in interest rates in one country makes savings more attractive and brings money flows from other countries, leading to an appreciation of the country's currency.
• The volume of exports and imports: These are affected by the difference in prices between countries caused by changes in interest rates and exchange rates. 
• Financial wealth of households and firms: This is also affected by the impact of interest rates on the price of assets such as equities, public and private corporate debt, etc.

The final impact of monetary policy can, therefore, vary significantly depending on how all these factors play out, which is why central banks will have to adjust monetary policy over time.

On the one hand, an increase in interest rates means lower purchasing power for consumers. The cost of borrowing is more expensive (mortgages, credit cards, etc.), which reduces disposable income and slows spending. On the other hand, higher rates also mean that savings provide greater returns, resulting in an incentive to spend less and save more in exchange for a better return on money.

For businesses, this incentive for consumers to save rather than spend will primarily affect their revenue, as lower consumption will translate into lower demand for their goods and services. Secondly, as with consumers, higher interest rates mean more expensive financing, which reduces margins.

The core of the banking business is to take depositors' savings and use them to provide loans to customers who want to invest or purchase goods. The main return that banks earn, known as the net interest margin, comes from the difference between the interest it charges for lending money and the interest it pays on its customers’ deposits.

Therefore, changes in interest rates can directly affect the demand for loans and the volume of deposits, impacting banks’ profitability and overall strategy.

Banks' sensitivity to interest rate changes can vary significantly across countries, depending on their balance sheet structures, e.g. if loans are issued at fixed or variable rates, their hedging strategies (a way for banks to protect themselves from financial risks, like changes in interest rates), the economic environment, regulatory requirements, etc.

At Santander, our geographic diversification helps us offset the impact of changes to interest rates. We have businesses that benefit in the short term when interest rates rise (positive sensitivity) and others that are negatively affected (negative sensitivity).

For example:

• In Brazil and Chile, deposits are automatically linked to interest rates. If interest rates rise, it has a negative effect on the bank, as the cost of deposits increases at a faster pace than the interest it earns from loans. Therefore, the sensitivity is negative.
• In Europe, deposits are not directly linked to interest rates, so the sensitivity to higher interest rates is usually positive.

Our business diversification also plays a crucial role. In the consumer finance sector, the effects of a lower interest rate environment take longer to materialize due to its business model. Loan rates are typically fixed and their terms are longer, meaning that the impact of lower rates takes more time to feed through.

Additionally, we proactively manage our balance sheet across the countries where we operate in order to anticipate interest rate variations and try to minimize their impact on the P&L.

When applying for a mortgage, we can choose between three types of interest rates:

• Fixed (a percentage that never changes): With a fixed rate, we pay the same amount throughout the mortgage. The reference for setting this fixed rate is mainly the interest rates on long-term public debt (e.g. 10, 20 or 30-year government bonds).
• Variable: At a variable rate, the percentage of interest to be paid changes periodically (normally every 6 or 12 months) according to the fluctuations of a reference indicator, usually the Euribor. The Euribor is calculated as the average rate at which European banks lend money to each other.
• Mixed (a combination of fixed and variable): A mixed-rate mortgage has a fixed interest rate for the early years of the loan (i.e. payments are fixed) and then changes to a variable rate based on a reference indicator.