It’s time to clear up a few things that have many of us confused!
First of all, why is the national interest rate one number, but your mortgage rate has another, your credit cards each have their own and so does your student loan? (Asking for a friend.)
If you’re used to people getting excited because “Interest rates are down!” but aren’t really sure why we’re celebrating, that’s OK. If you’ve been seeing Wall Street Journal headlines about interest rates in company chats and social media feeds, but are pretending to know what everyone’s talking about, that’s fine too.
Does anyone really understand anything about finance? We don’t know. But what we can tell you is that there are a few reasons to learn about interest rates now. First of all, as of April 2020, interest rates are down (don’t worry, we expand on that below). Secondly, understanding the concept will help you, for example, decide which mortgage option will save you the most money, or when is a good time to refinance.
What is an interest rate?
Put simply, an interest rate is a percentage of a loan that is tacked onto payments as the cost of borrowing the money.
What is the national interest rate?
The national interest rate is applied to money that commercial banks borrow from the national central bank, called the Federal Reserve (affectionately known as the Fed). Similar to the way we might borrow money from our parents (ahem … and by we, we mean our friends), banks borrow money from the Fed when their cash flow runs low.
What are consumer interest rates?
By contrast, consumer interest rates are applied to any type of loan, from mortgages to student and car loans, which are borrowed by individual consumers. When interest rates are down, borrowing money costs less – woohoo! But low rates aren’t all good news. Savings and other bank accounts accrue interest, so when rates are low, your money earns (often referred to as yields) less money. Bummer.
How does the national interest rate affect consumer interest rates?
When the national rate goes up, banks pass that cost along to consumers. Sound unfair? Actually, it’s what’s supposed to happen.
The process allows the Fed to stimulate the economy by dropping the rate, which makes it less expensive for folks to take out loans. But since lower interest rates earn less for money in savings and other accounts, lowering the rate also helps the fed encourage consumers to take their dollars out and invest them in other things — like government bonds, for example.
However, when the economy improves, inflation happens, and too much of it can be a problem. What’s inflation? Google defines it as “the general increase in prices and fall in the purchasing value of money.” (Thanks, G!) Therefore, when the purchasing value of money gets too low, the Fed raises its interest rate back up again to curb inflation.
So there you have it – a brief breakdown of the concept of interest rates. Have a newfound interest in economics? Check out our post “The 5 Determining Factors in Your Credit Score.”