Interest rates figure into most people’s financial decisions, from the price of a home mortgage to the amount charged on a credit card balance. Consumers consider them when choosing a loan or credit card, market watchers follow them to gauge economic trends and the Federal Reserve adjusts them to keep the economy running smoothly. Understanding how interest rates work can help you make better financial decisions.
Interest is the cost of borrowing money, expressed as a percentage of the principal (the original amount borrowed) and typically noted annually, but can be calculated monthly, daily or any other period. Generally, borrowers want low interest rates that reduce the cost of borrowing, while lenders seek high rates to maximize profits.
Higher interest rates tend to restrain consumer spending, which can slow the economy. On the other hand, lower rates can encourage borrowing by individuals and businesses and provide an injection of capital into markets, stimulating growth.
The Federal Reserve sets interest rates for the country, deciding when to lower them in times of economic stagnation and raising them to cool the economy in times of overheating or inflation concerns. These decisions are based on a complex mix of economic data and the monetary policies outlined in the Fed’s monetary policy statement.
When rates rise, consumers pay more when they borrow for large purchases, such as homes or cars, and they also receive lower returns on savings vehicles like bank accounts and Certificates of Deposit. But many older Americans rely on savings and pensions for a portion of their income, so they benefit from rate hikes, which bring more dollars to the pockets of those who save.