Why does it seem like the amount of money you owe always seems to get bigger, but your checking account doesn’t grow the same way? It’s all in the interest rates, one of those things that everyone says, but nobody takes the time to explain.
The good news? They’re pretty straightforward to understand. The bad news? They can impact your life in a lot of ways. Let’s break it down.
Hey MoneyLion, my name’s Austin Hankwitz and I talk about personal finance and investing online. I’m from a small town in northeast Tennessee and didn’t know a thing about interest rates until I opened my first savings account.
Money Life Lesson: Let’s start with the easy stuff. What’s an interest rate? It’s the cost of borrowing money or the reward that you receive for saving it.
You may be borrowing money to buy your first house or get that new car. But borrowing money isn’t free – you have to pay a fee on top of that, usually expressed as a percentage called an interest rate.
On the other hand, banks are actually borrowing money from you when you leave cash in a savings account. Right? You’re letting the bank borrow money in the form of deposits, and they’re paying you interest for the use of it. This “use” is usually them giving out other loans.
The Daily Deposit:
That’s simple enough – but who sets the rates? The Federal Reserve does. “The Fed” changes interest rates to manage inflation and keep us out of recessions. When interest rates are low, banks are able to give out loans at a lower cost to you and me – allowing us to borrow money to spend more easily.
During the pandemic, the Fed lowered interest rates a lot to encourage people to borrow and spend more money. We’re now nearly 2 years into this and interest rates are still low. People can take advantage of the low-interest rate by doing things like refinancing their mortgage – especially if they’re paying PMI or “private mortgage insurance.”
So why do rates ever get raised? Because remember – the Federal Reserve is also in charge of inflation, not just recessions. When the economy returns to normal strength, rates need to be raised back up to prevent runaway inflation.
Interest rates heavily influence saving and spending. Businesses and consumers monitor these rates before borrowing money. Savers review interest rates before stashing their money into a checking or savings account. Tweaks to the interest rate can lead to economic prosperity or recessions. Want the inside scoop on interest rates? We’ll explain everything you need to know.
Interest rates explained
Interest rates represent the cost of borrowing money and the reward for saving it. You’ll pay a fee to borrow money which gets expressed as an interest rate. Lenders charge this fee to lower their risk and earn a return on their investment.
In exchange for the interest fee, you get access to capital sooner. Home and auto buyers often finance most of the purchase. If you make a 20% down payment, you’ll only need $100,000 to buy a $500,000 house. The bank is on the hook for the remaining $400,000 that must be paid, hence the interest payments.
You’ll earn interest on your checking and savings accounts. The banks borrow this money for issuing loans. Since banks make money from the interest rates, they provide lower interest rates to incentivize savers. This dynamic explains why checking account rates fall far below mortgage interest rates.
Why do interest rates change?
Interest rates occasionally change. The Federal Reserve System, or the Fed, sets rate percentages as part of the monetary policy. When the Fed keeps rates the same, it’s business as usual.
However, the Fed may increase or decrease rates at any time. Both decisions have pros and cons. Plus, the Fed often lowers rates to stimulate economic activity.
Lower rates help businesses and consumers borrow more money. People can more easily afford a house, while companies can fund expansion efforts. Lower rates also help homeowners refinance for better rates and ditch private mortgage insurance if they’re paying into it.
Lower rates lower the cost of borrowing money. This policy increases the money supply but also risks inflation. Too much money will rapidly deteriorate the dollar’s purchasing power, leading to inflation.
The Fed counters inflation by raising rates, thereby raising the cost of borrowing money. This policy restores order for the domestic currency, but it also risks a significant economic slowdown.
These pros and cons explain why the Fed gradually modifies interest rates. Rushing to raise rates can lead to a recession. Lowering rates too quickly or resorting to negative interest rates can double the prices of goods and services.
Interest rates impact our budget. We need to plan for them and look for the most attractive rates for our purchases.