What’s the big deal with interest rates?

It’s everywhere you turn…

“The Fed’s outlook on interest rates…”
“In this interest rate environment, you should be looking to…”
“When interest rates normalize, you should expect…”

You’ll notice that each of these sentences tails off. That’s because everyone has a different opinion of what will happen when interest rates change. But what’s the big deal with interest rates being at the current levels and what happens when they change? 

Let’s cover the basics…

The Federal Open Market Committee determines interest rates, for the short-term. This is comprised of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents.

When there is too much money in the economy (i.e. people are spending too much), this group will raise interest rates to make it more appealing to put money in the bank and save it. Conversely, when there is too little money (i.e. people are not spending enough), interest rates are lowered which makes it more attractive to spend money now (not save) and even borrow money from the bank to do so.

So based on this explanation, there is an obvious reason why you should be concerned about interest rates – if you’re saving money for the short term. “Short-term” could mean parking money for short-term expenses or even your emergency fund. In times of low interest rates your money isn’t going to grow.

When looking at investing over the long-term, short-term interest rates are the start of a cycle of changes. When short-term interest rates increase, it typically impacts all investments that pay interest payments. If a 1-year bank CD jumps from 0.1% to 2%, then it makes sense for other investments that are longer terms than 1-year to be paying more than 2%. That makes sense – why would you give your money to someone for four years for less interest than someone taking your money for one year?

Unfortunately, we’re in an environment where interest rates are around the 1% level if you invest in a bank’s one-year CD. 1% on $10,000 is $100. Yep, one hundred dollars for an entire year of not having access to your money.

That’s why people want interest rates to go up – because they want their money in the bank to earn more.

But there’s a problem when it comes to that.

Instead of using a CD, let’s say you went and bought a bond from the government. A government bond acts like a CD in that you lend your money to the government, they pay you interest payments for a period of time, and then they give you your money back. But short-term bonds typically pay more interest than bank CDs.

Let’s say the bond you purchase is a $10,000 10-year Treasury bond (meaning you shelled out $10,000 to own it), and they pay you $16/month over a ten-year period, and then gave you the $10,000 back at the end – typical to current interest rates.

What if interest rates went up, and payments changed to $25/month?

You’d look to sell the bond you have, and purchase the one that pays $25/month.

But who wants to buy yours that pays $16/month when they can go to the government and get the same one that pays $25/month?

No one.

The way you end up selling your bond is by selling it at a discount – say $9,750. This way the buyer spends $9,750, gets the $16/month payments, but gets $10,000 at the end.

(There is a formula to figure out what the discounted price would be to break even, but I won’t bore you with that today).

For bond investors who may be selling their bonds soon, an interest rate increase is a bad thing. People who hold longer-term bonds, say over 7 years, will find that the discount they have to give should they go to sell them is a lot higher than shorter-term bonds.

For that reason, in low interest rate environments, investors hold bonds that are shorter in length to protect them from having a drastic decline in the value of their bonds when interest rates go up.

But is there anything good that has come out of low interest rates?

Yes. If you remember the paragraph above where the Federal Reserve lowers rates to get people spending, it does work. Lower rates on credit cards, mortgages, and car loans.

If you have a mortgage interest rate of over 4% (on a 30 year, fixed rate note), then you can refinance your loan and get a mortgage for under 4%. This only makes sense if you plan to stay in your house for a while, as the cost to close this loan will require some funds.

If you want to buy a new car / boat / fun toy – interest rates are low to do this right now. Many places even have 0% loans for a long period of time, just to move their inventory and try to convince you to be a loyal customer.

If you are in the position to buy something and are ok using debt to make the purchase, now is a good time to do it. Once the Federal Reserve raises interest rates again, then you’ll see mortgage and personal loan rates go back up again as well.

So how does this affect you and your finances?

Easy.

As an investor – it’s tricky right now, as your stable investments won’t earn much interest. But don’t give up on them; they’re supposed to be there for diversification.

As a consumer – now is a great time to use other people’s money, and use loans to purchase items. However, you should do this prudently and always make sure it fits into your current spending and savings plan.