There’s been much talk in the media lately about rising interest rates. In addition to rattling the stock market, the focus on higher rates has also worried many potential homebuyers who face higher mortgage payments, as well as those in the market for a vehicle, who could be saddled with higher monthly payments.
Given those and other troublesome effects, it would seem that higher rates are bad and lower rates are good. In reality, the truth lies somewhere in between. And understanding interest rates more fully can help you put current headlines into perspective. Here’s what to know.
What drives interest rates, and why are they in the news?
While there are a number of factors that drive interest rates, in the U.S., they tend to follow a rate that the Federal Reserve charges to banks that borrow money. When the Fed lowers interest rates, it encourages borrowing and tends to spark more economic activity (think more people building new homes or companies investing in new equipment). If economic activity becomes too robust, it can lead to inflation. That’s often when the Fed raises rates (which is sometimes referred to as tightening policy). This makes borrowing more expensive and tends to lower economic activity.
Currently, the Fed’s economic policymakers are raising interest rate levels in an attempt to cool the economy enough to slow inflation, yet not so much as to cause a recession. While interest rates remain low by historical measures, the Fed has signaled that rates will continue to increase throughout the year.
How interest rates going up can impact you
There are a number of different ways interest rates can impact your money. Here are some of the most common:
- Credit cards or other adjustable-rate loans. If you have credit card or other adjustable-rate debt, the interest you’ll be charged will increase as rates rise. This would be a good time to review debt and consider your plan to pay it down.
- Homebuying. The housing market has been strong lately, fueled in part by low interest rates. The good news is that if you have locked in a fixed mortgage rate, your rate won’t increase as interest rates rise elsewhere. But for new homebuyers, increased rates will increase the monthly payment.
- Savings or bond investments. If you’re earning interest on money you have in savings or invested in bonds, you’ll likely see that interest increase.
What’s the point of interest anyway?
The rate of interest is a way of expressing the cost of borrowing money as a percentage of the total amount borrowed for a year. For example, borrowing $1,000 at a 5 percent interest rate means paying $50 a year in interest. That cost incorporates a few key elements. One is the time value of money, which is another way of saying that having a dollar in hand today is worth more than having a dollar a year from now. After all, having money today means you can put it to work by spending or investing it now rather than waiting. Borrowers are willing to pay an amount for the privilege of being able to use the money immediately.
Risk and inflation
Another component of interest rates is risk. For lenders, there is always the chance that the borrower won’t pay back what’s owed. That’s called credit risk, and lenders demand compensation for that risk, which figures into the interest rate that is charged.
Another key element is inflation. Lenders expect that the dollars they receive when they are repaid will have the same purchasing power as the dollars they loaned. If lenders expect that inflation will erode the value of those dollars by decreasing their purchasing power — meaning it will take more dollars to buy the same amount of goods or services — lenders will demand a higher rate of interest to compensate for the loss of value due to inflation.
Who benefits from higher or lower interest rates?
Generally speaking, lower interest rates favor borrowers and higher rates favor lenders. The past several years have been advantageous for borrowers, as interest rates have been extremely low by historical standards. That means if you have money, it will be easier to put it to work and make more money. But if you’re planning to borrow money, you will pay more.
While headlines about the impact of rising rates can be unnerving, history has shown that the economy has grown during periods of low and high inflation, as well as during times without inflation. It has also grown when interest rates were low as well as when they were high. Working with a financial advisor can help you to feel more confident at times like this. Your advisor can help you build a plan to grow your wealth over time and through different economic conditions.