How do interest rates change?

Published on Jul 01, 2021

How do interest rates change?

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. 

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.