An interest rate is the percentage of principal charged by the lender for the use of its money. The principal is the amount of money loaned. Interest rates affect the cost of loans. As a result, they can speed up or slow down the economy.
The Federal Reserve manages interest rates to achieve ideal economic growth. But first, we have to understand how do interest rates work and how are interest rates determined.
What Are Interest Rates?
An interest rate is either the cost of borrowing money or the reward for saving it. It is calculated as a percentage of the amount borrowed or saved. You borrow money from banks when you take out a home mortgage. Other loans can be used for buying a car, an appliance, or paying for education.
Banks borrow money from you in the form of deposits, and interest is what they pay you for the use of the money deposited. They use the money from deposits to fund loans.
Banks charge borrowers a slightly higher interest rate than they pay depositors. The difference is their profit. Since banks compete with each other for both depositors and borrowers, interest rates remain within a narrow range of each other.
How Do Interest Rates Work?
The bank applies the interest rate to the total unpaid portion of your loan or credit card balance, and you must pay at least the interest in each compounding period. If not, your outstanding debt will increase even though you are making payments.
Although interest rates are very competitive, they aren't the same. A bank will charge higher interest rates if it thinks there's a lower chance the debt will get repaid. For that reason, banks will tend to assign a higher interest rate to revolving loans such as credit cards, as these types of loans are more expensive to manage. Banks also charge higher rates to people they consider risky; The higher your credit score, the lower the interest rate you will have to pay.
Fixed Vs. Variable Interest Rates
Banks charge fixed rates or variable rates. Fixed rates remain the same throughout the life of the loan. Initially, your payments consist mostly of interest payments. As time goes on, you pay a higher and higher percentage of the debt principal. Most conventional mortgages are fixed-rate loans.
Variable rates change with the prime rate. When the rate rises, so will the payment on your loan. With these loans, you must pay attention to the prime rate, which is based on the fed funds rate. With either type of loan, you can generally make an extra payment at any time toward the principal, helping you to pay the debt off sooner.
How Are Interest Rates Determined?
Interest rates are determined by either Treasury note yields or the fed funds rate. The Federal Reserve sets the federal funds rate as the benchmark for short-term interest rates. The fed funds rate is what banks charge each other for overnight loans.
Treasury note yields are determined by the demand for U.S. Treasuries, which are sold at auction. When demand is high, investors pay more for the bonds. As a result, their yields are lower. Low Treasury yields affect interest rates on long-term bonds, such as 15-year and 30-year mortgages.
Impact of High Versus Low-Interest Rates
High-interest rates make loans more expensive. When interest rates are high, fewer people and businesses can afford to borrow. That lowers the amount of credit available to fund purchases, slowing consumer demand. At the same time, it encourages more people to save because they receive more on their savings rate. High-interest rates also reduce the capital available to expand businesses, strangling supply. This reduction in liquidity slows the economy.
Low-interest rates have the opposite effect on the economy. Low mortgage rates have the same effect as lower housing prices, stimulating demand for real estate. Savings rates fall. When savers find they get less interest on their deposits, they might decide to spend more. They might also put their money into slightly riskier but more profitable investments, which drives up stock prices.
Closing Thoughts
In summary, how do interest rates work? It affects how you spend money.
When interest rates are high, bank loans cost more. People and businesses borrow less and save more. Demand falls and companies sell less. The economy shrinks. If it goes too far, it could turn into a recession. When interest rates fall, the opposite happens. People and companies borrow more, save less, and boost economic growth. But as good as this sounds, low interest rates can create inflation as too much money chasing too few goods.
The Federal Reserve manages inflation and recession by controlling interest rates, so pay attention to the Fed's announcements on falling or rising interest rates.
