When a lender loans you money, in addition to repaying the principal you pay a percentage of the principal amount; this percentage is the interest rate. These fees charged on the loaned amount affect the cost of loans and therefore may affect the rate of economic growth. In trying to achieve ideal economic growth, the Federal Reserve manages interest rates.
The Federal Reserve is the central bank of the US. It has the responsibility of keeping prices stable by ensuring that inflation does not get out of hand. It also promotes job creation by pushing down interest rates to make it cheaper to borrow money. In particular, the Fed adjusts the federal funds rate, which is the rate that banks charge each other when they need to borrow money from each other for the short term, typically overnight.
Higher interest rates make borrowing more expensive. Lower interest rates make borrowing less expensive. The cheaper it is to borrow, the more likely it is that individuals and businesses will take out loans. This favors spending, which drives the economy and creates more jobs. But if inflation is high and things become very expensive, the Fed will slow down the economy by pushing up interest rates and making it more expensive to borrow.
When it becomes more expensive to borrow, fewer people take out loans, people buy fewer things, and the demand for goods and services decreases. A drop in demand encourages businesses to reduce prices, resulting in stabilization. In good economic times, interest rates will rise. In bad economic times, interest rates will fall. Today, in part because of the global pandemic, interest rates are at historic lows.
What Is an Interest Rate?
An interest rate refers to both the cost of borrowing money and the reward for saving money. The rate is a percentage of the amount borrowed or saved. For example, you can borrow money to pay for a home, a car, or even an education. Banks also borrow money from you in the form of deposits, and they pay you interest for using the money that you have deposited with them.
An annual interest rate of 10 percent means that $10 is paid in interest for every $100 borrowed or saved. Banks typically charge higher interest rates on the loans they provide than they pay to depositors. The difference between what they charge borrowers and what they pay depositors is their profit (not counting fees and other sources of revenue). Since banks compete with each other for borrowers and depositors, the interest rates that they charge borrowers or pay depositors tend to be the same.
How Interest Rates Work
Interest rates are applied to the total unpaid portion of your loan or credit balance, and a bank expects you to pay the interest on a loan in at least each compounding period. Failure to pay the interest increases your outstanding debt. If a bank believes, on the basis of your credit report, that the chances or your repaying the a loan in full are relatively low, it will charge you an interest rate higher than it charges borrowers whom it regards as a better risk. This is why your credit score matters when you apply for a loan. The lower your credit score, the higher the interest rate you must pay.
A major component of the interest rate that banks charge is determined by the yields on Treasury notes or by the federal funds rate. The federal funds rate is set by the Federal Reserve and is the benchmark for short-term interest rates. It is this federal funds rate that banks charge each other for overnight loans. The federal funds rate has a direct bearing on the nation’s money supply and therefore on the health of the economy.
The yields of Treasury notes are determined by the demand for Treasury notes sold at auction. The higher the demand, the more investors pay for them and the lower the yields. When Treasury yields are low, the interest rates that are charged on long-term bonds are also low. For example, the Treasury yield on a three-month bill is 1.56 percent; that of a 30-year bond is 2.05 percent. The Treasury publishes daily updates of the yields for these securities on their website.
The interest rate that a borrower pays also depends on the type of loan, which may be a home mortgage, a credit card loan, a car loan, or a payday loan, among others. Banks typically charge higher interest rates on revolving loans like credit cards, in large part because these kinds of loans are cost more to manage. The interest rates for payday loans are also usually very high. Mortgage loans with fixed rates are less affected by a general rise or fall in interest rates. Before you secure a loan or invest your money, determine the interest rate that you will pay or receive.
What Happens When Interest Rates Rise?
The federal funds rate is what banks use to lend each other money. This rate changes daily and affects all other loan rates, so the federal funds rate is taken as indicating whether interest rates are rising or falling. The changes can result in inflation or recession. When interest rates are high, loans become more expensive. Fewer people and businesses can afford to borrow, lowering the overall spending in the economy.
The greater cost of loans has a ripple effect; less credit is available for funding purchases and consumer demand slows, leading to a drop in inflation. On the other hand, people have an incentive to save more since the savings rate is higher. Higher interest rates also reduce the amount of capital available to expand businesses, thereby reducing supply. The ultimate effect is reduced liquidity, which slows down economic growth.
What Happens When Interest Rates Fall?
Lower interest rates make business loans more affordable. They foster business expansion and increase the number of jobs in the economy. A lower general rate of interest means lower mortgage rates, making housing cheaper and stimulating demand for real estate. On the downside, depositors earn less interest for their savings, encouraging savers to spend more.
Persons who had planned to save their money may use it instead to invest in riskier but more profitable investments, effectively driving up stock prices. Although low-interest rates have many benefits and are preferred by the federal government and the Federal Reserve, they can result in inflation. Too much liquidity means that demand outstrips supply, leading to an increase in prices.
Are Changing Rates Good or Bad?
Changing interest rates can be bad or good depending on whether the rates are rising or falling. Every time the Federal Reserve raises or lowers its interest rate target, consumers are affected, since federal funds rate has a great impact on how much interest you pay on your loans or earn for your savings. Here are some of the ways interest rates may affect you:
1. Mortgage payments
The interest rate for a fixed mortgage does not change in concert with changes in other interest rates. But if the interest rate of your mortgage rate is adjustable, it may increase or decrease depending on variations in the general rate of interest. A rise in interest rates means an increase in your monthly mortgage payments; a fall in interest rates means a decrease in your monthly mortgage payments. If you are considering refinancing in order to convert a variable-rate loan to a fixed-rate loan, it is a good idea to negotiate with your lender when interest rates are low. This will help you lock in a lower interest rate.
2. Credit card rates
The annual percentage rate (APR) of credit cards varies from time to time. When the interest rate rises, it increases the total interest you must pay on your account balance. A falling interest rate lowers the interest you must pay, making it easier for you to pay your debts faster.
3. Car loans
If you are planning to finance a car, try to borrow when the interest rate is low so that your loan is as inexpensive as possible. If you are already making payments on a high-interest car loan, or you cannot wait for a low-interest environment before financing the purchase of a car, refinance when the interest rate is lower to reduce the total amount you have to pay.
4. Return on savings
One advantage of a rising interest rates is that your savings earn a higher interest rate. It becomes more rewarding to save using basic savings accounts, certificates of deposit, and money market accounts. But the increase in the interest on your savings may not be very dramatic; interest rates usually change slowly.
Conclusion and Recommendations
Interest rates affect the economy by affecting the cost of stocks and bonds and the spending patterns of consumers and businesses, and interest rates may cause inflation or recessions. In general, the impact of a rise or a fall in interest rates begins to be felt after about twelve months. Adjustments of the federal funds rate can help keep the economy balanced for longer periods.
To make sound investment decisions, you need to understand how interest rates interact with the economy. Before making decisions about when to borrow money, you should check the prevailing interest rates and determine what they mean for the money you want to borrow.