"A high-interest climate functions similarly to a captivating trap, relentlessly drawing in financial resources"
In the Euro area, long-term interest rates are approximately half of long-term local interest rates in Iceland. This disparity is noteworthy, as Iceland's interest rates are also higher than in countries that are considerably more indebted than Iceland.
The high interest charges in Iceland, as a percentage of GDP, are significantly higher than in neighbouring countries and five to six times higher than in the other Nordic countries. This situation is primarily due to Iceland's high domestic interest rate, which reflects factors such as higher inflation expectations, currency risk, and tighter monetary policy aimed at controlling inflation and stabilising the economy.
As of mid-2025, Iceland’s benchmark interest rate stands at around 7.5%, which is substantially higher than the Euro Area’s 2.15% and rates in other Nordic countries (often below 3-4%) and many developed economies with higher debt burdens.
Several key reasons contribute to this scenario. Inflation and monetary policy play a significant role, with Iceland having experienced relatively higher inflation rates historically. This has driven the Central Bank of Iceland to maintain higher interest rates to control price increases and preserve currency stability. Higher interest rates also compensate lenders for inflation risk.
Currency and country risk are also factors. Iceland’s small, open economy is exposed to currency volatility, which increases risk premiums embedded in interest rates. Lenders require higher returns for taking on this additional risk compared to larger, more stable economies.
Economic recovery and debt levels also play a role. Although Iceland’s overall government debt as a percentage of GDP has decreased significantly since the 2011 post-crisis peak, it still remains notable compared to some peers, contributing to cautious lending behaviour and risk premiums.
Lastly, Iceland’s high cost of living, especially for housing, suggests strong demand for loans but also increased costs for lenders. This could reinforce higher interest rates in the domestic market.
The potential consequences of these high interest charges for Iceland’s economy and welfare system include increased costs of borrowing, debt servicing pressure, welfare system stress, potential financial strain, and increased risk of default for households and firms with variable-rate debt.
Hanna Katrín Friðriksson, a Member of Parliament for The Liberal Reform Party, has emphasised the importance of not forgetting the interest rate differential. She has also highlighted that the high interest environment in Iceland is a "magic trap" that absorbs money that could be better spent elsewhere, such as the welfare system.
If interest charges in Iceland were to be reduced by half, approximately 40-50 billion ISK could be saved. This savings could secure contracts with self-employed psychologists, speech therapists, specialists, and others. The expected interest expense next year in Iceland is 95 billion ISK, with the increase in interest expenses over the last few years being approximately 50-60 billion ISK.
In conclusion, Iceland’s relatively high interest rates reflect the interplay of inflation control, currency risk, and economic recovery considerations. While they help stabilise the economy, these high charges pose challenges for equitable growth and welfare support, necessitating careful fiscal and monetary policy management.
In this context, the high interest rates in Iceland, with a benchmark rate of 7.5%, significantly impact the economy and welfare system, as a reduction of half could save around 40-50 billion ISK that could be allocated to essential services like healthcare. Furthermore, these high interest rates are interconnected with the country's environment, finance, and business, as they are influenced by factors such as inflation control, currency risk, and economic recovery, which are essential for maintaining a stable economy, but limit equitable growth and welfare support.
