How do interest rates work?

Key takeaways

• Interest is the extra cost a borrower pays when repaying a loan, typically expressed as a percentage.
• On the flip side, interest can also be earned when you invest in fixed income securities or save money in a bank or cash management account, since you're essentially lending out your money.
• Interest rates affect many aspects of personal finance, business, and the economy and influence decisions about saving, borrowing, and investing.

What are interest rates?

Interest is the cost of borrowing or the earnings from saving or investing money. The rate of interest is expressed as a percentage of the loan or deposit amount.

If you borrow money, you'll pay interest. If you save or invest money in an interest-bearing account, you'll earn interest. When interest rates are high, you'll pay more to borrow but earn more on your savings and investments. With low interest rates, you'll pay less to borrow but earn less on your investments.

Interest income is paid by many bank products like savings accounts and certificates of deposit (CDs). It's also paid by bonds. Note that you're required to report interest income on your taxes, and it's taxed at your usual income tax rate.

How are interest rates determined?

The U.S. Federal Reserve, often referred to as "the Fed," is the central bank of the United States. It plays 2 key roles: promoting maximum employment and setting and influencing interest rates to promote economic stability. The Fed achieves these goals by adjusting the federal funds rate, which is the target interest rate at which banks lend to each other overnight. This rate isn't directly applied to consumer loans or savings accounts, but it serves as a benchmark for many other interest rates in the economy. When the Fed raises interest rates, its intent is to slow down economic growth and reduce potential inflation. When it lowers interest rates, it can help stimulate economic growth.

The Fed's actions are connected to its responsibility for promoting employment and economic stability. The way it acts directly affects the yields and prices of and demand for investments. Its actions have the strongest effect on short-term investments, including:

• Money market funds, which invest in short-term, low-risk securities. When the federal funds rate rises, yields on these securities typically increase.
• CDs, which offer fixed rates over a designated period. When the federal funds rate rises, banks often increase interest rates on new CDs to encourage more deposits.

What factors affect interest rates?

Central banks set key interest rates, like the federal funds rate, which serve as benchmarks for other interest rates in the economy. They can also act in ways that affect interest rates, for example, by buying and selling government securities.

The 2 main factors that influence the direction of Fed policy and interest rates are:

• Inflation. Since higher rates make borrowing more expensive, raising them can reduce consumer spending and slow down economic growth. That means raising interest rates can generally help curb inflation.
• Employment data. When the economy is doing well and employment numbers are high, central banks may raise interest rates to keep inflation in check. On the other hand, if employment levels are low, central banks may lower interest rates to help stimulate consumer activity and encourage job creation.

How interest rates affect borrowing and debt

It's important to understand the role interest rates play when determining how to manage your debt. Doing so can help you make better financial decisions, whether you're considering taking out a loan, refinancing debt, or managing your credit.

High interest rates mean that it's more expensive to borrow money. Lenders tend to be more cautious when rates are high, possibly applying stricter requirements for borrowers, so fewer people borrow.

Low interest rates make it easier to access credit. Lenders are more willing to extend credit, and more people are likely to borrow since the cost is lower.

How interest rates affect your savings and investments

Interest rates can affect how much people save and invest. When interest rates rise, new bonds are issued with higher interest rates, which makes them more appealing to investors. As a result, existing bonds with lower interest rates become less attractive and their value decreases. Higher interest rates can weigh on stock prices, particularly for companies with high debt levels, as borrowing costs increase.

The reverse can happen when interest rates are lowered. Low interest rates affect investments by encouraging people to move money away from lower-yielding bonds and saving accounts into riskier assets like stocks.

Simple vs. compound

The difference between simple interest and compound interest is how the interest is calculated and applied over time.

Simple interest is calculated only on the original amount, or principal, of a loan or investment. It doesn't consider any interest that has been accrued over previous periods.

Compound interest is calculated on the principal amount and any accrued interest, which can cause your debt to grow much faster. This can negatively impact your finances if you're borrowing and paying interest. For example, if you don’t make regular payments on your credit card, the debt can skyrocket because of the compounding interest.

However, when it comes to investing, compound interest is a key reason why starting early can be beneficial, particularly for long-term goals.

How to manage your money with changing rates

Whether navigating rising interest rates or falling interest rates, it's important to focus on your long-term goals and not day-to-day market fluctuations. Changing interest rates are simply an indicator of the economy's current state. The most important thing is to maintain a well-diversified portfolio that aligns with your goals and risk tolerance.

Diversifying your portfolio can help mitigate some risks associated with rate changes, since you'll have a balanced mix of stocks, bonds, and cash that can help spread your risk across different asset types. And be sure to compare interest rates when deciding where to keep your cash to make sure you're getting a competitive yield.

If you feel the urge to make major changes to your portfolio based on interest rates, revisit your financial goals. If your life circumstances haven't changed, you may want to make minor adjustments or no changes at all. If you have questions, consider financial advice. Revisiting your financial goals and remembering why you started can help you stay on track.