What an interest rate increase—or decrease—really means
Have you ever wondered what an interest rate hike or cut means for your personal finances? When the Federal Reserve changes rates, it can influence how much interest you pay on things like loans and credit cards, as well as the amount you could earn on savings accounts. Learn the basics about how interest rates work and why they’re important to understand.
Why interest rates go up and down
You may have noticed that interest rates on loans and savings accounts can change from time to time.
For instance, one year you might pay a certain interest rate on a car loan, but the next time you shop for a car, that rate might be several percentage points higher or lower.
So what makes interest rates rise and fall?
Now, the actual process is much more complicated, but essentially, interest rates fluctuate mostly as a result of things the Federal Reserve does to keep our economy stable.
The Federal Reserve (or “the Fed”) is the central bank of the United States and it has two main goals:
to keep prices stable—that is, to make sure inflation doesn’t get out of control, and to encourage job creation when employment is low.
When a lot of people are out of work, the Fed might try to encourage job creation by pushing interest rates down.
When interest rates go down, it becomes cheaper to borrow money, which means people and companies will be more likely to take out loans. And as a result, they’ll spend more money. That increased spending will fuel the economy and, hopefully, lead to the creation of more jobs.
Think about it this way, when you buy a home, you might also hire movers and painters, maybe buy some new furniture and plant some flowers from the garden center. And the person who sold you the home needs a new place to live, so they might do the same. The net effect of all this spending helps create new jobs.
On the other hand, if inflation is high and prices are rising too fast, the Fed might try to slow down the economy and steady those prices by pushing interest rates up. When interest rates go up, it becomes more expensive to take out a loan. In turn people will be less likely to borrow money and they’ll buy fewer things.
Meaning there’ll be less demand for goods and services, which will cause sellers to drop their prices.
And, as a result, those prices will stabilize.
By encouraging interest rates to rise and fall at certain times, the Fed is trying to stabilize prices, create jobs, and keep the economy secure. Understanding why rates might rise and fall, can help you make more informed financial decisions.