When discussing bank accounts, investments, loans, and mortgages, interest is an important concept to understand. In financial terms, interest is the price paid for the temporary use of someone else’s funds, and an interest rate is the percentage of a sum borrowed that is attributable to interest. Whether you are a lender, a borrower, or both, it is important to consider how changing interest rates may affect your financial decision making.
The Purpose of Interest
Borrowing money can help you accomplish a variety of financial goals, and the cost of borrowing is interest. When you take out a loan, you receive a lump sum of money up front and are obligated to pay it back over time, generally with interest. Because of the interest expense, you end up owing more than you initially borrowed. The tradeoff, however, is that you receive funds to accomplish your goals, such as buying a house, funding a college education, or starting a business. Given the cost of interest, which can add up significantly over time, it is important to make sure that any debt you assume is affordable and worth the cost over the long term.
To a lender, interest represents the compensation for the service and risk of lending money. In addition to giving up the ability to spend the money at the present, a lender assumes certain risks. One obvious risk is that the borrower will not pay back the loan in a timely manner, if ever. Inflation creates another risk. In general, prices tend to rise over time; therefore, goods and services will likely cost more by the time a lender is paid back money borrowed. Effectively, the future spending power of the money is reduced by inflation because more dollars are needed to purchase the same amount of goods and services. Interest paid on a loan helps to cushion the effects of inflation for the lender.
Supply and Demand
Interest rates often fluctuate, according to the supply and demand of credit, which is money available to be lent and borrowed. In general, one individual’s financing habits, such as carrying a loan or saving in fixed-interest accounts, will not affect the amount of credit available to the economy enough to change interest rates. However, a general trend in consumer banking, investing, and debt can have an effect on interest rates. Businesses, governments, and foreign entities also affect the supply and demand of credit according to their lending and borrowing patterns. An increase in the supply of credit, often associated with a decrease in demand for it, tends to lower rates. Conversely, a decrease in supply of credit, often coupled with an increase in demand for it, tends to raise rates.
The Role of the Fed
As a part of the U.S. government’s monetary policy, the Federal Reserve Board (the Fed) manipulates interest rates in an effort to control money and credit conditions in the economy. Because of this, lenders and borrowers can look to the Fed for an indication of how interest rates may change in the future.
In order to influence the economy, the Fed buys or sells previously issued government securities, which affects the federal funds rate. This is the interest rate that institutions charge each other for very short-term loans, and it determines the interest rates banks use for commercial lending. For example, when the Fed sells securities, money from banks is used for these transactions; this lowers the amount available for lending, which then leads to a rise in interest rates. In contrast, when the Fed buys government securities, banks are left with more money than is needed for lending; this increase in supply of credit, in turn, lowers interest rates.
Lower interest rates tend to make it easier for individuals to borrow. Since less money is spent on interest, more funds may be available to spend on other goods and services. Higher interest rates are often an incentive for individuals to save and invest, in order to take advantage of the greater amount of interest to be earned. As a lender and a borrower, it is important to understand how changing interest rates may affect your saving and borrowing habits. This knowledge can help you make wise decisions in pursuit of your financial goals.