About Interest Rates
With any loan or investment process, such as buying a car or opening a 401(k) for retirement, investors are going to hear about interest rates in regards to the money they are spending. An interest rate is best thought of as the cost of borrowing money, or conversely, the compensation one party receives for the service and risk of lending money to another party. What do you need to know about interest rates before investing yourself?
Interest rates are constantly changing figures, and different loans will offer you different types of rates as an investor or buyer. When it comes to the valuation of a company, and in turn stock pricing for that entity, interest rates play a fundamental role. In the United States, the Fed has held its official interest rate near zero since December 2008 in an effort to foster an environment that encourages growth and investment in the US economy in the midst of the Great Recession, continuing into the period of recovery.
Whether you are a lender, borrower, investor, or some combination of the three, you need to understand the reasons for changes in interest rates, differences in rates, and how they affect your money.
The Supply and Demand of Credit
The law of supply and demand does, believe it or not, apply to interest rates. In the event there is an increase in the demand for credit, interest rates will rise, and vice versa. For example, when more companies look for capital investments to expand operations, interest rates rise because there is only so much capital available for banks and other lenders to provide to these companies. Likewise, for the individual buyer, interest rates for new car loans may rise during the time of year that new-car sales are peaking and the number of buyers seeking a loan increase.
Similarly, an increase in the supply of credit reduces interest rates, while a decrease in the supply will have the opposite effect. To put this into perspective, consider an individual opening a bank account. When a new consumer opens a bank account, that gives the bank access to more money to provide borrowers, increasing the supply of credit and lowering available interest rates.
The Role of Inflation
One of the dirty words of economics is inflation. Simply put, inflation is a measurement of how much prices rise over a period of time, and inflation directly impacts the value of money. The higher the inflation rate goes, the less you can purchase with the same amount of money. Similarly, higher inflation means higher interest rates in most cases. This occurs because lenders demand higher interest rates as compensation for the decreased purchasing power of the money they will receive as repayment in the future.
The Role of Government
As mentioned earlier, the US Fed has been holding its interest rates near zero since the onset of the Great Recession. In fact, there has not been a hike in the federal interest rate level since December 2006. Federal funds rates established by the government affect the interest rate banks set on money they lend, and eventually that has a trickle-down impact on short-term lending rates as well.
The Fed influences open-market interest rates by buying or selling previously issued US securities. The more the government buys, the more money you will see injected into banks and into the lending community, pushing interest rates lower. The sale of government securities removes money from the banks and interest rates go up because the supply of credit has shrunk.
When it comes to a personal loan, the interest rate is often dependent upon the credit risk, time, tax considerations, and convertibility of the loan. The greater the chance a bank sees in a loan not being repaid, the higher the interest rate. A secured loan often has a much lower interest rate. Government-issued debt securities have a low risk and interest is tax free, so the interest rate on these loans is often low as well.
Finally, long-term loans face higher interest rates because inflation is expected to impact the long-term face value of the loan, increase the chances of the debt not being repaid, or not having anywhere near the same value when it is. Loans that can be converted back to money quickly, on the other hand, carry very low rates.
As you can see, interest rates are more than simple percentages presented to you during investment meetings or loan application processes. There is a complex interplay of numerous factors occurring; each of which has a different push-pull impact on the current interest rate. For more information, contact Paul Miller CFP®.