If you have interest rate exposure – either through debt you pay interest on OR investments you earn interest from – you need to understand why interest rates change. You will learn what an interest rate is, what factors affect interest rates, how to read an interest rate yield curve, and more.
Why Do Interest Rates Change?
My goal here at Family Finance Mom is to equip all financial decision-makers with the basic financial skills needed to make the best decisions you can for you and your family’s future. And the best place to start is with an understanding of the basic building blocks of finance: interest rates and capital structure. Today, I am addressing interest rates and why interest rates change.
What is an interest rate?
Interest rates are what you are charged when you borrow money, whether it be on a credit card or through a loan. It is also what you earn when you save money – because a savings account is effectively a bank borrowing money from you. It is how people in finance measure or quantify risk, setting the price you must pay to convince a lender to lend you money. Interest rates are calculated as a percentage rate, and typically quoted annually.
At a very simple level, if I pay $10 interest a year on a $100 loan, my annual interest rate is 10%. Later, I will explain different ways you may see interest rates quoted and what each one means in terms of what you actually pay.
What Affects Interest Rates?
Have you ever wondered why a 30-year mortgage rate is 4% today (but was 9% or more for our parents 30 years ago)? Or why your credit card interest rate is 20%, but your student loans only charge 7%, and yet you see 0% interest rate loans quoted for new cars on commercials?
Interest rates are determined by a small handful of risk factors. Some of these factors are market specific, affecting all interest rates and everyone similarly – this is called rate risk. Other risk factors are dependent on the individual borrower, and even the individual loan. This borrower specific risk is called credit risk.
Rate risk is driven by several factors. First, there is the risk of rising inflation. And the longer your debt is outstanding, the higher this risk is. This is why generally longer-dated loans will have higher interest rates. Second, there is liquidity risk. If a borrower has committed their money to you, their money is tied up and not available for use or investment elsewhere.
Credit risk is borrower based. It is simply a gauge of how likely you are to pay back your loan. Credit risk can be reduced when debt is linked to a valuable asset – like a mortgage for a home. If you don’t pay the debt, the debt is repaid by seizing the asset.
Changes in the Interest Rate
I’m going to have a finance nerd moment right now – but interest rates are a super important topic for RIGHT NOW. Because for the first time, in literally decades, interest rates are changing a lot. Last month, the Federal Reserve (commonly known as “The Fed”) announced plans to raise the Federal funds rate up to 3-3.5% over the next 2 years due to forecasted rising inflation.
This is HUGE, considering we have lived in a persistent low interest rate environment for nearly a decade since the housing market collapsed in the mid 2000s, and really even before that after the tech bubble burst in the early 2000s. For many of us in early adulthood, a low-interest rate environment is the only credit environment we have ever known – and borrowing money is about to get a lot more expensive. It’s easiest to explain changes in the interest rate over time, and how The Fed’s monetary policy affects rates, by looking at the yield curve at different points in time.
What is the Yield Curve?
A yield curve is a graph depicting interest rates across different maturities for similar debt, in this case, US Treasuries. A normal yield curve is upward sloping, with shorter-term maturities having lower interest rates than longer-dated maturities. Short term rates are essentially set by The Fed (more on that below), while longer-dated maturities are set by the market – investors will only buy debt at an interest rate that adequately compensates them for the risk.
An upward sloping curve means that investors expect economic growth, which will cause prices to rise, also known as inflation, and as a result, expects the Fed to raise short-term rates in the future to reduce this inflation risk. The 1995 curve below is a normal yield curve. The curve also returns to normal after a recession, when the Fed drops the Federal funds rate – this is the case for the 2002 and 2008 curves below.
A downward sloping, or inverted, curve, as seen in 2006, is frequently investors signaling the risk of recession. In 2006, the downward sloping yield curve was the precursor to the housing market collapse. Long-term rates dropped in the market before the Fed lowered short-term rates. A flat yield curve signals economic uncertainty. Today’s curve is approaching flat. The Fed has signaled and already started to raise short-term interest rates, but the market hasn’t increased long-term rates as quickly yet.
Who is The Fed?
A poll of my followers via Instagram stories showed nearly 7 out of 10 of you aren’t entirely sure who The Fed is… and the same is true for most Americans.
Short-term interest rates are effectively determined by the Federal Reserve Bank, the central bank of the United States. They set the Federal Funds rate, which is the rate they charge banks who need short-term loans to meet bank reserve requirements.
The Federal Reserve is actually made up of 12 regional reserve banks, each overseen by a Governor. They hold Federal Open Market Committee meetings where the Governors of the reserve banks talk about economic forecasts and use it to inform and set monetary policy to help keep our economy growing at a normal and consistent rate. There is also a Chair of the Board of Governors, who is commonly considered the “face of The Fed.” The Chair is appointed by the President.
How Do Interest Rates Change What We Pay in Interest?
While all of the above is happening at a market level, how do the actions of the Fed and the market impact what we pay in interest as families? The Federal Funds rate, which short-term interest rates closely follow, is what banks pay for interbank loans. If the Federal Funds rate is low, banks lend more freely to us at lower rates. If short-term rates are higher, banks manage lending more tightly and lend to us at higher rates.
Meanwhile, longer-term rates, particularly the 30-year treasury, is typically the benchmark for mortgage rates. US Treasuries are frequently considered to be “risk-free” because they are backed by the US government. Your mortgage rate starts there. Then, an individual lender will evaluate your personal credit, as well as the loan to value on the specific home you are looking to purchase.
How to Evaluate Alternatives Using Interest Rates
Understanding interest rates is important not just in understanding the cost of our debt, but interest rates are also how financially savvy people evaluate financial alternatives.
Understanding interest rates helps you make better financial decisions
Do you want to make this investment or that one? Is the rate of return, or interest earned, enough to compensate for the risks you are taking?
To evaluate alternatives, start with the current Treasury yield curve as your baseline. Any bank, investor, and even you as an individual can put your money in US treasuries, backed by the US government and earn those rates of return, essentially risk-free. Therefore, any other investment, with more credit risk, has to pay more.
Understanding How Interest Rates are Quoted & Applied
Be sure you also understand the interest rate being quoted. Most loans, saving accounts and mortgages are quoted at a nominal interest rate – this is a simple interest rate, like 10%. In reality, interest is typically charged monthly (or even daily in some cases for credit cards).
Related Post: Money and the Magic of Compounding
They take the simple 10%, divide it by the periods and apply it to your balance at that interval – so you are actually being charged 10% / 12, or 0.83%, monthly. Compounded over the course of the year, your effective annualized percentage rate is actually 10.47%. That may not seem like a big difference, but on large balances, paid over long periods of time, it can really add up. You can learn more about the powerful impact of compounding here.
Here at Family Finance Mom, my goal is to empower all of you to have the financial skills you need to make the best decisions you can for your family. I hope this discussion of interest rates has helped explain not only why interest rates change, but also how the finance users interest rates as a measurement of risk and what factors affect interest rates.
Finally, I hope you now understand how changes in interest rates affect you, both given your current debt obligations and investments, as well as your future financial plans. And now you know who the Fed is and what they do too!
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