If you’re borrowing money through a financial institution to purchase a home, buy an automobile, pay for college tuition, open up a credit card account or have access to a line of credit, you’re paying something called interest for use of those funds. And while you know that sometimes rates go up, sometimes rates go down and sometimes rates stay the same from one year to the next, it may help to understand more about what an interest rate is and why interest rates may fluctuate.
Below you’ll find some commonly asked questions about interest rates to help you understand how they work and how they impact the economy.
What are interest rates?
An interest rate, simply put, is the cost of borrowing money. One way to think about interest is as a “rental fee” for borrowing. There are two scenarios that involve an interest rate between a lender and a borrower. When a consumer borrows money from a bank in the form of a loan, the interest rate is the amount that’s charged, usually as a percentage, by the lender to the borrower. The rate is referred to as the annual percentage rate or APR. The rate may be variable or fixed. A variable interest rate will increase or decrease as market interest rates change. A fixed rate will remain the same no matter how market interest rates may fluctuate.
When a consumer deposits money into their bank account, such as a savings account, the consumer earns interest, since the bank uses the money and—in a sense—is borrowing from the consumer. The bank will pay the consumer an annual interest rate for the temporary use of that money. This rate is referred to as the annual percentage yield or APY.
Who is “the Fed”?
The Federal Reserve, or “the Fed” as it’s commonly referred to, is the central bank of the United States and is an independent government agency that doesn’t need approval from any other branch of the government. The Fed studies economic trends and makes monetary policy decisions by regulating interest rates and the availability of money. In addition, the Fed supervises and regulates banks to ensure they are safe and adequate for keeping people’s money, and they play a major role in clearing checks and processing electronic payments, and distributing physical money to the nation's banks.
How does the Fed affect rates?
When you hear that the Fed has decided to raise or lower interest rates, it’s referencing something called the federal funds rate — the rate banks charge each other for loans. Depending on the current state of the economy, the Fed can help regulate it by either raising or lowering rates. For example, the Fed may raise interest rates, making borrowing money more difficult in an effort to prevent inflation. However, if the economy is slow, the Fed may lower rates to encourage borrowing and spending to keep the system flowing.
How have interest rates changed over time?
Before the rate increase in December 2015, the Fed hadn’t raised interest rates since 2006. And when the recession hit in 2008, the Fed dropped the funds rate to almost zero, leaving interest rates low for a long time. Whether raising or lowering rates, changes have typically been minimal, with a mere quarter increase or decrease each time.
When the Fed raises rates, what does it mean for the wallet of the average consumer?
Whether you’re borrowing money, saving or investing, a rate increase could have an impact. If you have a variable rate loan, credit card or line of credit, a rate increase may notch up your monthly payment.
If you’re a saver with a savings account or Certificate of Deposit (CD), you may eventually start to see higher interest on your deposits. However, any immediate increase would likely be minimal, so don’t expect to see big changes to your wallet overnight.
So now that you know a little more about how interest rates work, any future increase or decrease the Fed makes hopefully will make a little more sense to you.