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Understanding what interest rates are, how they work, and what factors affect interest rates for consumers is an important part of managing your finances. If you have any type of debt, like credit cards, student loan, car loan, or a mortgage on a property, the interest rate affects how much you pay over the time you have the loan for the privilege of borrowing the money. This Money Chat will help explain the impact interest rates have on your financial wellness and how they relate to the economy.
The goal of this Money Chat is to empower consumers with knowledge and education about interest rates that can help with making healthy financial choices as well as help with resolving debt. We hope to provide a basic roadmap for the path to debt resolution.
What Are Interest Rates?
Interest is, most simply, the price of borrowing money. An initial loan amount, also known as the principal, is repaid to the lender by the borrower over time. The lender’s charge (or fee) for loaning the money is interest and is added to the borrower’s repayment. The interest rate is a percentage of the principal amount and determined by various factors including the risk a borrower will not repay the loan. An interest rate is typically calculated on an annual basis and is recognized as annual percentage rate (APR.)
How Do Interest Rates Work?
Creditworthiness is a big factor that impacts interest rates. Lenders commonly charge higher interest rates to less credit-worthy borrowers (lower credit score) and lower interest rates to those with higher creditworthiness (higher credit score) because they are more likely to repay the debt. Anyone who is loaning money can charge interest, although there are laws protecting consumers that limit how much interest can be charged on certain types of loans.
In addition to credit history, the borrower’s employment information and debt to income ratio will be reviewed to ensure the borrower can afford to repay the loan. The amount of the loan to the value of property or purchase, for example, and the length and payment frequency could also impact the amount of interest a borrower is charged.
Maintaining A Positive Credit Report
A credit report reflecting negative items and a low credit score will make it more difficult to secure a loan. Lenders will set interest rates higher for those with lower credit scores to offset the increased risk of default, or non-payment. Certain types of loans could potentially increase an interest rate because of a negative item on your report, even on accounts that have been paid on time every month.
One type of credit score is created by the Fair Isaac Corporation, called FICO® Scores. FICO® Scores are determined using an evaluation of repayment history, the number and age of open credit accounts, the percentage of available credit used, and often includes recent credit inquiries. The importance of maintaining a positive credit report is an essential factor in obtaining a low interest rate.
Staying Current with Loan Payments
Borrowers are often willing to pay interest to spend money immediately instead of waiting to save money to make a purchase. They tend to spend more money to take out auto loans or home loans when interest rates are low and the cost over time is in their manageable budget. Staying current with loan payments is essential to lower interest rates, avoiding late fees, and maintaining good credit history.
Spending money with a credit card is spending borrowed money, loaned to you based on your ability to repay the loan. Many people use credit cards and pay off their balances each month in full, incurring no fees or interest. If a credit card balance is not paid in full and rolls from month to month, consumers are paying interest on money that has already been spent. Missed payments could incur additional fees, penalty interest rates and impact your credit score.
- A credit card was used for a $2,000 purchase and the consumer stopped making new charges. The card has an interest rate of 19% and the minimum payment required is 2% of the balance (amount of the loan still owed) per month.
- It will take more than 22 years to pay off the card, even though the 2% per month minimum payment was paid each month.
- The amount to repay grows each and every day for the borrower because of interest.
2% pays the interest and a tiny fraction of the principal.
- It will take a significant amount of time to pay off debt when only paying a minimum payment per month.
- The interest charged in the above scenario will be nearly $5,000 and to pay off the original $2,000. The consumer may ultimately pay $7,000 or several times the original balance.
Impact on the Economy
Changing interest rates impact the U.S. markets. When consumers are paying less interest, it gives them more money to spend which creates a ripple effect of increased spending across the broader economy. However, paying higher interest rates means that consumers will not have as much disposable income and will likely cut back on spending. Credit available to the economy decreases as lenders decide to defer (allowing borrowers an opportunity to guarantee late payment) repayment of their loans.
In the example above, postponing a credit card payment, or several, will increase the overall payment and interest for the borrower. The impact to the broader economy is a decrease of the amount of credit now available in the market, and will, in turn, increase interest rates. As a result, people start spending less because higher interest rates mean higher borrowing costs. The demand for goods and services will drop, and inflation will fall.
Federal Reserve System Monetary Policy
The Federal Reserve System (FRS) referred to as “the Fed,” our government agency serving as the nation’s central bank, can intervene to set interest rates. It is usually done to avoid either inflation or a recession. Too little money in the market can mean a recession is likely to occur as businesses and consumers severely curtailed spending. Too much money, and the value of money falls through inflation. When interest rates are rising and falling, the Fed will adjust the federal funds rate to keep rising prices under control.
The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight and is set by the Federal Open Market Committee (FOMC), the monetary policy-making body of the FRS. The rate is used by banks to lend money to one another and affects all other loans as a result, causing rising and falling interest rates. When interest rates are rising, and businesses and consumers cut back on spending, earnings begin to fall and stock prices drop accordingly.
Increasing the Supply of Credit
Opening an account with a bank is lending money to the bank. An increase in the amount of money made available to borrowers increases the supply of credit. Depending on the type of account (a certificate of deposit will return a higher interest rate than a checking account), the bank can use that money for its business and investment activities or lend that money to other customers. An increase in the amount of money made available to borrowers increases the supply of credit available to the economy.
Consumers with an interest-bearing account should inquire about the amount of interest earned and the minimum balance requirements. Little money from interest is returned from these accounts unless a significant amount of money is in the account. Strict minimum payment requirements may also result in fees that could potentially be more than the annual interest earned.
Final Notes About Factors Impacting Interest Rates
Wise lenders and borrowers will pay close attention to interest rates. It is best practice to read and understand the terms of your financing and savings arrangements, pay close attention to hidden fees and requirements. Learning more about how interest rates impact price stability and influence economic growth, and credit supply in the market will help achieve long-term financial wellness.
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Thank You to Our Sponsor
This article was sponsored by MCU Holdings, LLC a professional third-party debt collection company providing customized debt collection programs for creditor businesses and best-in-class experiences for consumers. Our main headquarters is located in Coral Springs, FL. Learn more about MCU Holdings on our LinkedIn profile, our Facebook page, and the MCU Holdings YouTube channel.
The information contained in this article is meant to serve as general guidance for consumers and not meant to serve as comprehensive financial advice. For questions about your individual circumstance, finances, or accounts, please contact your creditor(s) and/or financial advisor directly.