Ever notice all the news coverage that accompanies rumors of rising interest rates? That’s because interest rates are a measure of the health of the economy.
So why do interest rates change, and what determines their rate? Let’s look at some factors that contribute to interest rates in the United States.
What is Interest?
Interest is the cost you will pay for borrowing money from a lender. Banks and lenders are businesses, and like other businesses, they rely on profits to survive. Charging interest on loans is one of the primary ways banks make money.
It’s about supply and demand
The primary driver of interest rates is the supply/demand relationship. We can understand supply and demand by looking at the pricing strategy of a retail store.
- High Supply + Low Demand = Lower Prices: If the store gets a large shipment of sweaters in July, they have a high supply and low demand. These sweaters are going to go on sale. Likewise, high supply and low demand in the financial market cause interest rates to drop. This is what happens during a recession when customers aren’t making as many big purchases (low demand for loans) and so banks have lots of available funds (high supply).
- Low Supply + High Demand = Higher Prices: On the other hand, when you’re the only store in town that still has that hot new toy in stock right before the holidays, you might be able to raise your prices a bit. Low supply and high demand drive rates up. When the economy is booming and people are buying cars and houses, there is more demand for loans and the interest rates will increase.
- Economic forces are cyclical: So far, this reads a bit like a yo-yo with frequent ups and downs, and for good reason. The supply/demand relationship can have that effect. As high demand increases the interest rates, rising rates will decrease demand, ideally balancing itself out so that we don’t experience wildly erratic highs and lows.
The Federal Reserve changes rates
The market economy left unchecked works in the broadest theoretical sense, but when real people with real jobs and real businesses are considered, we can understand the benefit of a bit more stability. This is where the Fed comes in.
The Federal Reserve was created to set the monetary policies of the United States with the primary goals of minimizing inflation and unemployment. One of the ways it does this is by influencing the Federal Funds Rate, the interest rate that banks charge one another, and this becomes a baseline for interest rates nationwide.
Personal factors impact rates
The state of the economy (supply and demand) and the Federal Funds Rate generally determine the prime rate, or the benchmark rate. This is the rate that banks use for their best customers with excellent credit. Credit scores, loan terms, and other considerations can impact a customer’s personal interest rate, so don’t walk in expecting to be offered the prime rate. Variable rate loans are often determined in relation to the prime rate (i.e. 4.5% over prime, or prime+4.5%).
Understanding interest rates can help you manage your financial strategies so that you can time that home loan just right.
