If you have ever bought a house, signed for a loan, applied for a credit card, or opened a savings account, then you have some idea what interest rates are. When interest rates go up, credit becomes more expensive and you have to pay a higher percentage rate for a loan or credit card. At the same time, higher interest rates also mean you make more money from your savings or investments. But what drives interest rates up or down?
The Economics of Interest Rates
Like most things you can buy or sell, credit is a commodity. Everyone is familiar with the economic laws of supply and demand, where market conditions such as the quantity of goods a producer wishes to sell determines the price that consumers are willing to pay. Interest rates are affected by supply and demand as they relate to credit; demand borrowed money is what dictates interest rates.
Banks and credit unions offer credit as a product; it’s how they make money. If you borrow money to buy a house or a car, the amount of interest added to the loan are the fees charged by the lender. The interest rate is the cost of borrowing, which can make a big difference in the type of loan or credit card you apply for. Similarly, if you put your money in a savings account, certificate of deposit (CD), or money market account, the amount of interest you earn is a commission paid by the bank for holding (and using) your money.
Interest rates are what make banks and credit unions competitive. Credit unions usually offer lower interest rates than banks on mortgages, for example, which makes them more attractive to homebuyers. Some banks offer special deals on credit cards with low introductory interest rates to attract new customers. When saving money, you also want to look for a savings vehicle with the highest interest rate for maximum earnings.
However, interest rates are not arbitrary. They are set by the Federal Reserve Bank, a.k.a. the Fed.
How the Fed Sets Interest Rates
The Fed was created to help the government manage the U.S. economy. The Fed has two objectives: 1) keep prices stable and control inflation, and 2) stabilize market conditions to promote full employment.
Although the Fed has a number of tools at its disposal, interest rates are what it uses to try to direct the economy. If the economy starts to heat up, the Fed raises interest rates to make it more expensive to borrow money. If the economy needs a boost, lowering interest rates can encourage people to borrow money and thus stimulate growth.
After almost a decade of near-flat interest rates, the Fed has started to raise interest rates again. The unemployment rate is hovering around 3.8 percent, which is the lowest since 1969. Wages are starting to rise. More importantly, inflation has started to increase to a point where the Fed believes the economy is healthy. To rein in growth, the Fed is slowly increasing interest rates in order to cool things off and discourage overspending and overborrowing. However, if the Fed raises interest rates too fast, it could trigger a recession.
Why Interest Rates Matter to You
Why should you care about interest rates? In addition to the fact that they have a direct impact on how you borrow and save money, there are other considerations:
- Rising interest rates may mean this is the time to borrow. Because interest rates tend to rise, consumers who have been thinking about a major purchase such as a house or a car—anything that requires borrowing money—may decide to buy now, before borrowing money gets more expensive. If there is a pending rise in mortgage rates, for example, there could be an increase in homebuyers and sellers looking to cash in on the mortgage boom.
- Saving money yields higher returns. Putting money in CDs, bonds, investments, and other saving vehicles will mean a better nest egg. For variable rate savings accounts, the interest rates will pay more. For consumers looking to get more from their savings, higher interest rates may mean it’s time to move money into a CD or money market account that yields better returns.
- You get more money for retirement. With the baby boomer generation worrying about retirement, higher interest rates mean they get more from their retirement savings. Investing in CDs and money market accounts means they can stretch their retirement savings farther.
- Travelers get more buying power. When interest rates rise, the U.S. dollar becomes stronger. If you are buying foreign goods or thinking about a trip out of the country, the exchange rates should be more favorable and you will get more for your money.