The cost of loans and mortgages to consumers has been an important issue throughout the credit crunch. Following years of relatively cheap, relaxed lending, major economies are now experiencing heavy losses from unpaid loans – and as a result, lenders have made their loans more expensive (in the form of higher interest rates) and more difficult for consumers to obtain.

The Bank of England's recent base rate drop to 3% was designed to kick-start the loans market by offering a strong incentive for lenders to drop their own rates – and, in many cases, it appears to have worked. Several leading lenders cut their variable-rate mortgage products by the full 1.5%, with more expected to follow.

However, some lenders have chosen not to pass on the base rate cut, and some areas of lending such as personal loans and fixed-rate mortgages have so far seen little change.

So why is this? Why does the base rate affect lenders' interest rates for consumers, and why do some lenders choose to ignore base rate activity?

Bank of England base rate & loans

In short, the base rate is the interest rate at which lenders can borrow from the Bank of England, Britain's central bank. As borrowing from the Bank of England is a major source of funds for loans and mortgages, lenders usually set their consumer interest rates slightly above the base rate – which is how they make a profit on loans.

So in theory, when the base rate goes up, interest rates on loans and mortgages should also go up in order for the lenders to continue making a profit.

However, when the base rate falls, it isn't always so clear cut. Banks are often hesitant to reduce their interest rates without careful consideration, in case other market conditions compromise their returns on loans.

Currently, lenders are still aware that they stand to lose money from defaults on existing loans – either from people who borrowed too much when the loan market was thriving, or from people who may lose their jobs in the forthcoming recession. This uncertainty means some lenders are still unwilling to lower their interest rates.

LIBOR & loans

The base rate is not the only factor that influences lenders' decisions on interest rates. LIBOR (the London Inter-Bank Offered Rate), a measure of the rate at which banks lend between each other, is also a major deciding factor in how lenders set their rates (especially mortgages).

It's important to bear in mind that LIBOR is a measure – it is not pre-agreed, like the base rate. LIBOR is calculated according to the average rates at which banks are lending between each other. That means that when banks start lending to each other at lower rates of interest, LIBOR comes down.

In recent months, the LIBOR rate has been much higher than the base rate – meaning that the funds required to finance loans are more expensive to the lender than the base rate would suggest. This has prevented lenders from lowering rates in the past – which is why the previous base rate cut to 4.5% was largely ineffective. Since the base rate was dropped to 3%, though, more lenders have lowered their lending rates, and LIBOR has fallen accordingly.

So when will we see more interest rate cuts?

It's impossible to say how many lenders are willing to lower their interest rates at any given time, or when. What we can say, though, is that the base rate cut has encouraged a number of lenders to cut their rates, and LIBOR is falling accordingly – although it is still higher than the base rate.

Once LIBOR falls more closely in line with the base rate, we may see lenders start to compete with each other more aggressively – and that means lower interest rates on loans.