Interest rates and other central bank policies might seem abstract to many people. However, interest rate policies affect you, businesses, and the economy at large.
Generally, the work of the US Federal Reserve is to ensure that the economy is working in the right state. Not so active or too slow!
For instance, if the economy becomes too hot (books with activities), distortions like inflations are highly likely to occur and destabilize the economy. In such cases, the Federal Reserve steps in and raises the interest rates to bring about stability.
Does it seem complicated? Well, no need to worry. This article explores – what is interest rate and how it affects you – in the easiest way to understand.
Let’s start:
What Is Interest Rate?
What exactly is an interest rate? Simply put, an interest rate is the cost of borrowing money or the reward for saving it. For example, when you take out a loan, credit card, or mortgage, the interest rate determines how much extra you’ll pay on top of the original amount borrowed.
A higher interest rate means you pay more in interest costs over time. On the other hand, interest rates reward savers by paying a percentage yield on savings accounts, CDs, or bonds. The higher the interest rate, the more interest you earn.
Rates are typically expressed as a percentage, like 5% APR on a car loan or 0.5% APY on a savings account. The interest rates will fluctuate over time based on economic factors and central bank policies. But generally speaking, high interest rates benefit savers, while low rates are better for borrowers.
Understanding interest rates helps you make smart financial decisions on where to put your money or how much you’ll repay on a loan.
How Interest Rates Affect You
Interest rates impact our finances in many ways as consumers. When interest rates rise, borrowing money becomes more expensive as banks charge more. Your credit card APR, mortgage payments, and loan rates will likely increase with higher interest rates as the Prime Rate rises. This means your disposable income decreases as more money goes towards interest fees.
On the flip side, higher interest rates allow savings accounts, CDs, and bonds to offer better returns. So, you earn more from your deposited savings when rates increase.
However, higher returns on low-risk investments may cause investors to move money out of stocks or real estate. This can lead to declines in the prices of such assets.
Overall, interest rates influence how much income we have to spend or invest, as well as the availability and cost of credit. Therefore, you should stay informed on rate changes and adjust your finances accordingly.
How Interest Rates Affect Spending
When a lender extends a loan to a borrower, there is a probability that the loan may never be repaid. That’s why lenders include the interest as a reward for them risking their money. In other words, interest is the amount of money the lender earns once the borrower repays their loan. It is calculated as a percentage of the borrowed money and is referred to as the interest rate.
Through this action, lenders are willing to lend their money, and the consumers get instant ability to spend. Otherwise, consumers would have to save before making their purchases.
Lower interest rates encourage spending. Why? Consumers are more willing to borrow and spend as they don’t feel too pressured by the loan. For instance, with lower interest rates, people will borrow to spend on large purchases like cars and real estate.
On the other hand, higher interest rates lead to reduced spending. Since you are paying more for loans, credit cards, and mortgages, your disposable income reduces. Consequently, people have less to spend and are less willing to borrow as the banks charge more for each loan.
With less borrowing, spending is minimized. This affects the amount of money in the economy as consumers, businesses, and farmers cut their spending. It might even lead to unemployment.
How Interest Rates Affect Inflation and Recession
The Federal Funds Rate is a common term whenever there are changes in the interest rate. It is the bank-to-bank interest rate. They use it when lending money to each other, and it affects the rates of all other loans. As such, it is a good indicator of how the interest rates are fairing.
Changes in interest rates affect inflation and recession. For starters, inflation is the increase in prices of various products and services over a specific period. But while inflation results from a healthy economy, it can lead to reduced purchasing power if left unchecked.
As such, the Fed keeps monitoring inflation through various metrics like CPI and the PPT to ensure that it doesn’t go overboard. If these metrics surpass 2%-3% a year, the federal funds rate is increased to prevent further rise in prices.
So, does an increase in interest rates cause inflation? No! The opposite is true.
With higher rates, people borrow less, thus reducing purchasing power. This, in return, lowers the demand for goods and services, leading to a fall in inflation. This is what has been happening since 2022 in the US. The Fed has been increasing the interest rates to curb inflation.
When it comes to recessions, falling rates can easily end a recession. With a lower federal funds rate, consumers are more willing to borrow. Subsequently, this leads to increased spending, which brings to an end a period of slowed economic activity.
In 2022, the Fed reduced its rate to 1.25%, which saw the economy recover throughout 2023. In other words, lower rates mean more borrowing and spending.
How Interest Rates Affect Credit Cards
Have you ever thought about how interest rates affect credit cards? Well, higher interest rates mean expensive credit cards. You will be paying more for your purchases than when the interest rates are lower.
For instance, when the federal interest rate rises, your credit card’s APR also rises. This is because the federal funds rate determines how much interest banks charge each other for borrowed money. If banks-to-bank borrowing becomes expensive, so does lending to consumers.
This will affect every form of lending, including loans and credit cards. And since most credit cards offer a variable APR, it means that when the Federal funds rate increases, so do the Prime Rate and the APR. Paying your debt early or leveraging the 0% balance transfers APR is the best way to handle these changes.
