When discussing bank accounts, investments, loans, and mortgages, it is important to understand the concept of interest. Interest is the price you pay for the temporary use of someone else’s money. Borrowing money allows us to buy a house, go to college, or start a business. However, you have to pay the money back over time, with interest. Due to the these extra charges, you end up owing more than originally borrowed. Be sure you can afford a loan over the long-term.
The Purpose of Interest
To a lender, interest represents compensation for the service and risk of lending money. In addition to giving up the opportunity to use the money right away, a lender assumes certain risks. One obvious risk is that the borrower will not pay the loan back in a timely manner. Inflation creates another risk. Typically, prices rise over time; making goods and services cost more by the time the lender is paid back. In effect, the future spending power of the money borrowed is reduced by inflation. Because more dollars are needed to purchase the same amount of goods and services in the future, interest helps to cushion the effects of inflation.
Supply and Demand
Rates often fluctuate, according to the supply and demand of credit. In general, one person’s financial habits, such as carrying a loan or saving money in fixed-interest accounts, doesn’t affect the amount of credit available to borrowers enough to change rates. However, an overall trend in consumer banking, investing, and debt can have an effect on rates. Businesses, governments, and foreign entities also impact the supply and demand of credit according to their lending and borrowing patterns. An increase in the supply of credit, often associated with a decrease in demand for credit, tends to lower interest rates. Conversely, a decrease in the supply of credit, often coupled with an increase in demand for it, tends to raise interest rates.
The Role of the Fed
As a part of the U.S. government’s monetary policy, the Federal Reserve Board (the Fed) manipulates interest rates in an effort to control money and credit conditions in the economy. Consequently, lenders and borrowers look to the Fed for an indication of how rates may change in the future.
In order to influence the economy, the Fed buys or sells previously issued government securities, which affects the Federal funds rate. This is the interest rate that institutions charge each other for very short-term loans, as well as the rate banks use for commercial lending. For example, when the Fed sells securities, it uses money from banks to fund the transactions. This decreases the amount of money available for lending and increases interest rates. By contrast, when the Fed buys government securities, banks are have more money than they need for lending. This increases the supply of credit, thereby lowering rates.
Lower rates make it easier for people to borrow. Spending less money on interest means more money can be spend on goods and services. Higher rates are often an incentive for individuals to save and invest. As a lender or borrower, it is important to understand how changing interest rates can affect your saving or borrowing habits. This knowledge also helps in decision-making while pursuing your financial objectives.