What Are Interest Rates?
When people need to finance large purchases like a home or a car, start a business, or pay college tuition, they often turn to their bank for a loan. These loans can be short-term in nature, lasting just a few months, but they can also be longer-term, like mortgages, which can have a duration of as many as 30 years.
In return for lending people money, banks look to be repaid the principal of their loan along with interest. Thus, interest is the price you pay to borrow money, and the terms of interest set within the loan contract are called interest rates. The interest rate is usually denoted on an annual basis—it’s known as the annual percentage rate (APR).
Naturally, the higher the rate of interest, the larger a sum a borrower will owe their lender. For example, if you took out a $1,000 loan due in one year with a 10% interest rate, the total you would owe is $1,100. If the interest rate was only 5%, the amount you would owe would be less: $1,050.
But interest rates aren’t only used for lending. Banks add interest to savings accounts as an incentive to make deposits. This rate of interest is called an annual percentage yield (APY). Governments and corporations also entice investment in their bonds by offering investors interest. This rate of interest is known as the coupon rate.
What Are the Timeframes of Short-Term and Long-Term Rates?
Short-term interest rates, also known as money market rates, are typically used for loans with a maturity of under a year, such as money market funds, CDs, and Treasury bills. Short-term rates are really an average of daily interest rates.
Long-term interest rates usually apply to debt instruments with periods ranging between 1 and 30 years, such as bank loans, mortgages, credit lines, and government bonds. These rates track the 10-Year Treasury bill.
Which rates are better? Typically, short-term rates are lower than long-term rates because there is less risk involved in investing over a shorter time period: Can one assume a borrower will still be around in 30 years and will continue to make their payments on time?
For the same reason, those who invest in longer-term securities enjoy higher yields, because by lending their money to a corporation or the federal government for a longer timeframe, they are rewarded for assuming more risk.
Fixed vs. Variable Interest Rates: What’s the Difference?
Interest rates are categorized by their yield payments:
- Fixed rates are set, or unchanged, rates that apply to the term of a loan.
- Variable rates fluctuate periodically. In the case of adjustable-rate mortgages, the rates can change drastically, and if homeowners are not aware, they could go into default.
While fixed rates are typically higher than introductory variable rates, they are also more predictable. Borrowers, such as homeowners, can always refinance their loans during favorable interest rate environments.
Which Interest Rates Does the Fed Control?
Banks don’t just lend to consumers—they also lend to other banks, and the inter-bank lending they engage in must adhere to policies set by the Federal Reserve. The Fed’s job is to regulate the financial industry, ensure the stability of the financial markets, and maintain healthy levels of employment. It meets several times a year to review the economy at Federal Open Market Committee Meetings (FOMC).
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Every time the Fed meets, it sets a target interest rate range, which is known as the fed funds rate. Banks use this target as a standard for their prime rate, which is the rate that affects deposits, bank loans, credit card rates, adjustable-rate mortgages, and even some student loans.
When the economy is growing, and employment is healthy, the Fed might decide to keep the target fed funds rate unchanged. If economic conditions worsen, due to sudden circumstances like a natural disaster or an asset bubble, the Fed may lower the target rate to encourage lending in an attempt to steer the economy back on track. But if there’s inflation, the Fed may raise interest rates to quell volatility and price hikes until things can get back on track.
Which Interest Rates Are Tied to Mortgages?
The fed funds rate is not directly tied to mortgage rates, but the mortgage market tends to move in tandem with rising interest rates. When interest rates are cut, mortgage rates are also lowered, thus making it less expensive for people to buy a home.
In particular, fixed rates for 15 and 30-year mortgages track 10-Year Treasury bonds. These are bonds issued by the U.S. government that mature in 10 years. Treasury bond yields move inversely with interest rates, which means that when interest rates rise, bond prices fall, and vice versa. So, investors closely watch the daily yield of the 10-Year Treasury, which is available through the Department of the Treasury’s website. Falling yields signal to many that it’s a favorable time to make a home investment.
Which Interest Rates Are Tied to Savings?
In a nutshell, banks set interest rates on savings accounts. These rates are usually competitive with what other banks are offering.
Typically, banks do not offer higher interest rates on savings accounts than they charge on their loans. While banks want people to invest their savings with them, they also want to encourage lending and large expenditures; after all, banks don’t keep everyone’s money in a shoebox! Yes, they do keep a portion of their deposits on-hand as reserves, but they also utilize liquidity to lend money to other customers, which adds to their balance sheet.
Which Interest Rates Are Tied to Student Loans?
Most student loans, like federal student loans, have fixed interest rates that do not change over the lifetime of the loan. However, there are some types of variable-rate student loans that are affected by rising or declining interest rate environments. These are loans obtained from private lenders, such as banks.
Like other long-term interest rates, federal student loan rates are tied to the 10-Year Treasury.
How Do Interest Rates Affect the Economy?
Nearly every aspect of life as we know it is affected by changing interest rates. Rising interest rates make consumers more cautious about spending and making large purchases, which affects the housing market. Declining interest rates, on the other hand, make it more favorable for businesses to fund investments, build new factories, increase production, and hire new people. Lower rates spur economic growth and are generally celebrated by the stock market.
Are Interest Rates Affected by Inflation?
Yes. Rising prices are the hallmark of inflation, and when prices go up, people can’t afford to do many of the things they previously could do.
The Federal Reserve strives to maintain stability in the economy and keep its currency strong. It does not want prices to rise uncontrollably. That’s why it increases interest rates in inflationary environments, so as to discourage lending. It all comes down to supply and demand: When people cannot afford to buy things, demand falls, and thus, prices decline.
Why Are Interest Rates So Low?
Fueled by the implosion of mortgage-backed securities, the 2007–2008 financial crisis rattled global markets, and in response, the U.S. government added trillions of dollars in emergency stimulus to the economy and the housing market. It passed bills that strengthened regulation of the financial industry, and the Federal Reserve began a series of quantitative easing measures, slashing interest rates to nearly zero, to encourage consumer confidence and lending once again. Interest rates were kept at this low level for over a decade, and the stock market enjoyed a long bull market run as a result.
How Do I Calculate Interest Rates?
The calculation for interest rates is the sum of the principal plus interest (not to be confused with compounding interest, which is a bit more complicated):
Will Interest Rates Go Up Soon?
TheStreet’s Dan Weil believes Russia’s invasion of Ukraine will cause The Federal Reserve to hike interest rates by as many as 50 basis points at its next meeting.