How the UK credit rating downgrade affects your finances

What happened?

Credit rating agencies rate the credit worthiness of countries. The credit rating is a guide to the country's ability to repay its debts. On Friday Moody's, one of the agencies in question, cut its rating for the UK from AAA (the highest rating possible) to AA1. In theory, if the credit rating falls the cost of borrowing for the UK Government should go up. Cue Chicken Licken style 'the sky is falling in' headlines.

Was it a surprise?

The downgrade wasn't unexpected. The various rating agencies already had placed the UK's rating on a negative watch list because of the weak economic growth prospects and questionable ability to balance its books to repay its debts.

So the downgrade of the UK credit rating was not a case of 'if' but 'when'. Moody's was the first rating agency to downgrade the UK, the others (Standard & Poor's and Fitch) will likely follow suit.

How will the UK downgrade affect my finances?

The impact will be limited initially. From an investment perspective, the markets were fairly unphased by the news with the FTSE 100 finishing up on the first day of trading following the downgrade. Why? Numerous reasons but you must remember that a large proportion of earnings of the companies that make up the FTSE 100 are derived from abroad (around 80% is the often quoted figure).

What we are really seeing is the market reevaluating the UK, given the relative calm within the eurozone. Where once the UK and its currency were seen as a safe haven the markets are questioning the stability of  'UK plc'. As such sterling is losing its relative shine and the currency has weakened in recent months vs dollar and the euro. This means that our exports are cheaper but our imports are becoming more expensive. The first is good news for export business (hence a good thing for the economy and why equity markets remained bullish) but the latter is bad news for you and I. It could mean higher energy bills and a squeeze on our finances, or in other words increased inflation.

If the pound falls, as it is likely to carry on doing, then your holiday abroad, and your spending money, will be more expensive.

Continuing on at the investment theme, many people have said that a downgrade would cause a collapse in bond markets as the cost of Government borrowing would be reflected by higher yields. If that were the case annuity rates would go up, while bond investors could see capital losses. But don't forget that the bond market is rigged with the Bank of England buying the lion share of long dated gilts. Unsurprisingly the cost of borrowing (10 year gilt yields) have barely moved thus far.

Many doom-mongers claimed that mortgage rates would go up if the UK lost its AAA credit rating. But this is unlikely, certainly not in the short term, but possible down the line. Mortgage rates are tied to the Bank of England base rate, which is more short term and not dictated by the market. The Bank of England is not going to raise its rate any time soon.