How interest rates work

Interest rates can impact your financial life — from your house payments to your investments. Eight times a year, the Federal Open Market Committee (FOMC) votes on whether the Federal Reserve should raise or lower interest rates. The Federal Reserve is the central bank of the United States.

Deeksha Gupta, a finance professor at the Carey Business School at Johns Hopkins University, explained that it’s important to know when interest rates are changing. “People should be paying attention,” Gupta said. 

That’s because interest rate fluctuations can affect your personal finances — from the cost of a mortgage to the interest earned on a savings account. Understanding how interest rates work could help you make more informed financial decisions.

Understanding interest rates

So, what are interest rates? An interest rate can be:

• The amount a lender charges you when you borrow money. You’ll find this type of interest rate listed as a percentage of the principal amount you’re borrowing. 
• The rate you’re earning interest on money deposited into a savings account or a certificate of deposit (CD).  

The Federal Reserve’s decision to raise or lower what’s called the overnight rate — a short-term lending rate that impacts many other kinds of interest rates — can be a complicated one. 

“If the economy is struggling, the Federal Reserve will decrease rates to reduce borrowing costs and stimulate the economy,” Gupta explained. “If the economy is doing well, it will increase rates to prevent inflation.” 

Considering APRs and APYs

On some types of debt like a mortgage, you’ll have two rates to consider — an interest rate and an annual percentage rate (APR). The interest rate simply tells you the rate of interest you’re paying on the debt. In contrast, the APR reflects the average yearly cost you’ll be paying over the life of the loan, including costs like financing charges and fees. To better understand this rate, you may want to learn more about the various types of APRs. 

When it comes to earning interest on your savings or investments, you may be provided with both an interest rate and an annual percentage yield (APY) for the account. The interest rate tells you the percentage of interest you're earning on money deposited or invested. The APY lets you know the total interest you could earn during a year with the benefit of compound interest. According to the Consumer Financial Protection Bureau, compound interest is when you earn interest on your total deposits as well as on the interest already earned. When comparing accounts, check the APYs, but keep in mind, account fees can cut into interest earned. So, you’ll also want to compare fees when deciding where to put your money.

Reviewing rates and financial goals

Whether interest rates are moving up or down, you’ll want to know how the changes relate to your goals.

• If interest rates rise, interest on new loans or loans that don’t have a fixed rate, such as a line of credit or an adjustable-rate mortgage, will increase too. This increase may prevent you from reaching some financial goals, since you’ll now owe more money.
• When rates and borrowing costs drop, you may be able to lock in a lower interest rate for mortgages or pay less interest on certain types of credit. This could help you build up your savings or retirement accounts. 
• An account that pays you interest based on a variable rate could be affected by a change in the overnight rate. For example, if rates rise, the interest you earn on money in a savings account can also increase, and vice versa. However, the interest earned on fixed-rate accounts like certificates of deposit will not change.

There are other interest rate effects to consider. For example, housing prices tend to inflate when rates stay low over the long term. Additionally, interest rates can affect investment returns, such as on long-term bond yields. Wage growth may also be impacted.

Planning for interest rate fluctuations

Here are a few tips to help you plan for the effects of interest rate changes:

Pay down debt before rates rise. Whether rates are high or low, you can take steps to reduce your debt, especially adjustable-rate mortgage debt. When rates are low, more of your payment will go toward the principal than interest. Then when rates rise, your higher interest rate will be calculated on a lower loan amount. You can get an idea of how an interest rate fluctuation can affect a loan payment by using a loan calculator.

Reduce spending to save more. When you anticipate a rate increase, that’s the time to cut back on spending and put more into a savings account. Not only will you reduce the risk of increasing your debt, but you’ll have more money in your account when savings account rates go up.

Assess the best time to buy a home. If you think rates will fall, consider waiting to buy a home. Locking in a lower rate could save you thousands of dollars over the life of your mortgage. On the flip side, you can consider buying a house if you think rates will rise. The Consumer Financial Protection Bureau provides tools to help prospective homebuyers estimate interest costs. You can even explore typical mortgage interest rates based on your state. 

Staying informed on the economics of interest rates

It’s clear that interest rate movements can impact the economy and your finances. That’s why Gupta’s advice to pay attention to rate changes — and their potential effects — is key. “Some things, like your debt, could be felt almost immediately,” she said.

Once you know what interest rates are, how they work and the basics of interest rate economics, you’ll be better prepared to make a range of decisions. Be sure to stay informed as you decide whether to buy a home, pay down debt, shift your investments or open a new savings account.