Whenever you apply for financing for an item that you aren’t paying for upfront, you agree to pay interest to the institution that’s lending you the money. However, do you know what interest rates are and what they do? Read on to find out.
What are Interest Rates?
Interest rates are the percentage of the principal, or loan amount, that a lender charges you in exchange for your use of its funds. The deposits you make into your bank account are used by the bank to fund these loans. If you place your deposit into your savings account, you can earn interest each month in return.
Interest rates can have enormous trickle-down effects on the entire United States economy and your own financial life. America’s central bank, the Federal Reserve, adjusts interest rates to promote long-term economic balance. In 2019 alone, the Fed slashed rates three times in a bid to protect the slowing economy.
How Do Interest Rates Work?
When you borrow money from a lender or credit card company, they charge a fee for using their money. For example, if you borrow $500 and the interest rate is 2%, the total cost of the purchase would be $510.
You can also avoid paying interest when you pay your balance in full each month on your credit card. Some interest-free financing promotions waive interest if you pay off the entire balance within a certain timeframe, such as 24 months.
Banks and lenders charge interest for two primary reasons, and that is to earn profit and to protect themselves from risk. If you have a lower credit score, a bank might decide you’re a high default risk, and charge you a higher interest rate. That’s why people with high credit scores tend to get the lowest-interest loan and credit card offers.
Although interest rates normally sound like a bad thing, they can also be a good thing. When you place money in a savings account, the bank will pay you interest based on the size of your deposits. The way the bank sees it, you are offering them more money to “borrow” from you.
Besides for your credit history, lenders determine your interest rate based on a few other factors. This includes:
- The type of credit: A secured loan is backed by collateral, which means it poses a lower risk to the lender. For example, if you fail to pay your mortgage, the bank can seize your house. Unsecured credit, such as credit cards and most personal loans, come with much higher interest since the lender has no property to repossess if things go awry.
- The length of the loan: If you need a longer period to repay your loan, the interest rate will be higher than a short-term loan. Not only will your borrowing relationship with the lender last longer, but you’re also paying for the additional risk of possible default during the extended life of the loan.
Lenders may raise their long-term interest rates when a borrower requests a longer-term loan. That’s because the dollar amount will decline in value in several years, even in a healthy economy.
What Are Some Common Types of Interest Rates?
There are various types of interest rates, so the term is quite broad. Here are the most common types of interest rates you’re likely to hear about:
- Prime Interest Rate: Banks charge this interest rate for their most creditworthy corporate customers. The prime interest rate is used as a point of reference for other interest rates, including adjustable-rate mortgages, credit cards, and personal loans.
- Fed Interest Rate: The interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis. The Federal Reserve uses its federal funds rate to keep a healthy supply of available funds and to control inflation as well as other economic risks.
- Mortgage Rates: Purchasing real estate prompts a whole wave of other interest issues. Typically, you will have either a fixed-rate or adjustable loan. When you take out a fixed-rate loan, the interest rate remains the same throughout the lifetime of the loan. An adjustable-rate mortgage will likely start at a lower interest rate — saving you money upfront — but the rates will fluctuate based on changes in the market.
- Annual Percentage Rate: APR describes the interest rate as a yearly amount and includes all other loan-related fees, such as origination and transaction fees. While you might hear the term “interest rates” more frequently, the APR actually takes into account the total amount you’ll pay for the cost of borrowing.
- Discount rates: The rate the Federal Reserve charges other financial institutions that need to borrow its funds.
- Simple interest: Banks typically use a simple interest formula to calculate the interest on a loan or deposit. Simple interest applies to the principal loan amount. It is generally used for short-term loans or credit card balances.
- Compound interest: As opposed to simple interest, compound interest applies to the principal loan amount as well as the interest that has accrued for previous periods. It is typically used for longer-term loans or savings accounts and CDs.
How Does a Fed Funds Rate Hike Affect Interest Rates?
The Federal Reserve is the gatekeeper of America’s interest rates. It raises and lowers the federal funds’ rates in response to ebbs and flows in the economy. The Fed’s Federal Open Market Committee meets eight times a year to discuss the state of the economy.
When growth has slowed, and the economy needs a boost, the Fed will lower the fed funds rate. When the economy expands too rapidly, it can cause inflation, which the Fed fixes by raising the Fed funds rate.
Even though the fed funds rate refers to the rate that banks charge other banks for overnight loans, the effect on the broader U.S. economy goes much deeper. Once banks see that the Fed announced a fed funds hike, they will do the same and increase their prime rates. Prime rate increases will then result in higher interest rates on credit cards and home loans. A higher interest rate on savings accounts and CDs will also occur.
How a Change in Interest Rates Can Impact Your Financial Decisions
Interest rate changes affect every aspect of your financial life. Here’s what you need to know about interest rate impacts of the most commonly used financial products:
- Savings accounts: Interest rate cuts mean you’ll earn less money on your deposits; conversely, when the Fed hikes interest rates, savings accounts are where you’ll stand to benefit.
- Certificates of Deposit: Your rate is already locked in if you currently have CDs. However, if you intend to purchase a new CD, any rate cuts may lower the interest rate available to you, and a rate hike will increase the interest rate.
- Personal loans: If you have a personal loan with a variable rate, you may notice a change in the interest rate. If you have a fixed-rate loan, you won’t see a difference in the interest rate.
- Mortgage Loans: When interest rates rise while you are house-shopping, it could affect how much you could afford to pay for a home. Once you own your house, if you have a fixed-rate mortgage, you’ll be in good shape, but your interest rate could rise or fall with an adjustable-rate mortgage.
- Student loans: You can capitalize on lower interest rates by refinancing your student loans, which will lower your overall interest and shave a chunk off of your monthly payment. Federal loans do not change since they have fixed rates.
- Credit card interest rates: Most credit card interest rates are variable, meaning they change in response to the fluctuations in the central interest rate. However, they can also change at any time, even when other rates are stable.
How Interest Rates Impact the Economy
Interest rates have a huge impact on the whole U.S. economy, including consumer spending and the state of the stock market. However, each time the Fed changes interest rates, it’ll take at least a year for changes to take effect in other areas. These are the main ways interest rates affect the economy:
- Inflation: When interest rates sink too low, that can spur excessive purchases that lead to inflation. When the Federal Reserve notices that the economy is getting too close to exceeding their target inflation rate, they reverse the trend by cutting the federal funds rate, which will eventually slow Americans’ spending and cool down the economy.
- Recession: In times of recession, such as the financial crisis in 2008, the Fed slashed interest rates to nearly zero to help the economy stabilize. Those rates remained near zero until 2015. That move was intended to encourage consumers to resume spending since borrowing money then became much cheaper.
- Stock and Bond Market: Interest rates have a direct effect on the stock and bond market. When interest rates are high, businesses tend to rein in spending, which causes stock prices to drop. Lower interest rates spur more confidence and purchasing, which elevates stock prices. When interest rates rise, bond prices fall, and as rates decrease, bond prices rebound.
How Interest Rates Affect You
Interest rates rise and fall depending on economic growth or slowdown. When you’re aware of how the central interest rate guides the rates of other financial products, you can make smarter decisions with your spending, borrowing, and investing.
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Bottom Line
Interest rates are very important if you ever consider borrowing money, or even keeping money in a savings account. Therefore, it is a good idea to know what interest rates entail.
For more information on banking, check out more bank guides right here on HMB!
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