What Are Interest Rates?

An interest rate is the amount a lender charges a person or entity to borrow money. When the Federal Reserve shifts interest rates, the effects can be felt economy-wide, affecting everything from business profits to borrowers’ debts to the investment markets.

Interest rates, explained

Lenders charge interest as a percentage of the principal, or borrowed amount, on a loan. It’s often expressed as an annual percentage rate (APR) which includes the interest rate plus other borrowing costs. These rates may be fixed, or stay the same, or variable, which means the rate fluctuates.

Interest rates represent income for lenders and the cost of borrowing for borrowers. Borrowers may take out a loan to start a business, buy a home or car, or pay for college. Consumers can also earn interest on their savings accounts or some types of investments, such as bonds.

Generally, lower-risk borrowers pay less interest than high-risk borrowers, as the lender feels more confident that they’ll receive their money back.

The federal funds rate

Interest rates are influenced by several factors, including a country’s central bank. In the United States, the Federal Reserve can manipulate the federal funds rate, or how much banks charge each other for overnight lending. In turn, this can affect the prime rate (the base rate for determining interest on many types of loans).

When the Fed raises the funds rate, borrowing becomes more expensive, which can slow economic demand and reduce inflation. By contrast, lowering the funds raise lowers the cost of borrowing, leading to increased economic activity.

What this means for you

As a borrower, interest rates determine how much you’ll pay to borrow money. Higher rates increase the total cost of your loan, while lower rates reduce your loan costs.

But that’s not the only way interest rates affect you.

When the Fed raises the funds rate, consumers typically spend less money. As a result, businesses may post slower growth or lower revenues, which can scare off investors and lead to lower stock prices. When enough companies decline, the whole market drops, which can make stock ownership less desirable.

On the other hand, if the Fed lowers the funds rate, consumers and businesses borrow (and spend) more money. This spending fuels the economy and encourages investment as businesses post higher profits and increase production or expansion. That said, leaving rates too low for too long can raise inflation, leading to increased costs and supply chain problems.

Interest rates and bond prices also share an inverse relationship. When rates go up, bond prices fall, and vice versa. Bonds with longer maturities tend to see greater fluctuations based on interest rate changes.

In other words, a reduced federal funds rate leads to higher bond prices, but less interest earned. By contrast, higher interest rates means earning more interest on smaller bond values.

In short: As a consumer, interest rates greatly impact the price you pay to borrow money. But as an investor, they also affect your potential earnings as the economy reacts to higher or lower borrowing costs.

As such, when the Fed announces or enacts a rate change, it’s not uncommon for investors to move into defensive positions. While it can be tempting to switch to greener pastures, it may be better to focus on your long-term investment strategy. Over time, the impacts of interest rate changes will smooth out with a well-diversified portfolio.

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