Determining Your Interests on Interest Rates
Whether it is bank accounts, loans, investments or economic cycles, it is important to understand the concept of interest rates. In the simplest form, interest is the price you pay for the temporary use of someone else’s funds; making an interest rate the percentage of a borrowed amount that is attributable to interest. Whether you are a lender or a borrower, carefully consider how interest rates may affect your financial decisions as they will impact your outcomes.
The Purpose of Interest - The Borrower
Although borrowing money can help you accomplish a variety of financial goals, the cost of borrowing can be prohibitive, therefore it should not be an afterthought. When you take out a loan, like a mortgage, you receive a lump sum of money up front and are obligated to pay it back over time, generally with interest. Due to interest charges, you end up owing more than you actually borrowed. This trade-off can be beneficial to achieving your goals, like buying a house, paying for college or starting a business. With the additional cost of interest and its compounding nature over time, be sure that any debt you assume is budgeted and worth the expense over the long term.
The Purpose of Interest - The Lender
On the other side of the loan is the lender, for which interest represents compensation for both the service and risk of lending money. In addition to giving up the opportunity to spend the money now or have it compound at current risk-free rates of return, a lender assumes many risks. An obvious risk is that the borrower doesn’t pay back the loan in a timely manner, or worse, decides to stop paying and default. Inflation creates another risk. Typically, prices tend to rise over time; therefore, goods and services will likely cost more by the time a lender is paid back. In effect, the future spending power of the money borrowed is reduced by inflation because more dollars are needed to purchase the same amount of goods and services. Interest paid on a loan helps to cushion the effects of inflation for the lender.
Supply and Demand
Interest rates fluctuate based on the supply and demand of credit, which is the money available to be loaned and borrowed. An individual’s financial habits, such as carrying a loan or saving money in fixed-interest accounts, will not affect the amount of credit available to borrowers enough to change interest rates. However, an overall trend across individuals and institutions in consumer banking, investing, and debt can have an effect on interest rates. Businesses, governments, and foreign entities also impact the supply and demand of credit according to their lending and borrowing patterns. An increase in the supply of credit, often associated with a decrease in demand for credit, tends to lower interest rates. Conversely, a decrease in supply of credit, often coupled with an increase in demand for it, tends to raise interest rates.
The Role of the Fed
As a part our government’s monetary policy, the Federal Reserve Board (the Fed) manipulates interest rates in an effort to control money and credit conditions in the economy. Consequently, lenders, borrowers, investors, advisors (and pundits) look to the Fed for an indication of how interest rates may change in the future.
In order to influence the economy, the Fed buys or sells previously issued government securities, impacting the Federal funds rate. This is the interest rate that institutions charge each other for very short-term loans, as well as the interest rate banks use for commercial lending. For example, when the Fed sells securities, money from banks is used for these transactions; this lowers the amount available for lending, which raises interest rates. By contrast, when the Fed buys government securities, banks are left with more money than is needed for lending; this increase in the supply of credit, in turn, lowers interest rates.
About Your Bonds, Bond Funds and the Stock Market
This movement creates interest rate risk associated with investing in a bonds and bond mutual funds or exchange traded funds (ETFs), referred to as an inverse relationship. This means that as interest rates rise, generally, prices of existing bonds with lower interest rates will fall, and vice versa. With rates rising in 2018, we are seeing the price of existing bonds and bond funds/ETFs fall. However, the rate at which they decline varies pending on risk factors like inflation, liquidity, credit and duration (longer the time to maturity, the greater the swing).
Lower interest rates tend to make it easier for individuals to borrow. Since less money is spent on interest, more funds may be available to spend on other goods and services, which can drive economic activity and market cycles. Higher interest rates are often an incentive for individuals to save and invest, in order to take advantage of the greater amount of interest to be earned. This can slow down economic activity and shift the market cycle.
As a lender, borrower or investor, it is important to understand how changing interest rates may affect your saving or borrowing habits as well as your investment portfolios.
Please call me at (508) 834-7733 or directly schedule a meeting to learn more about impact of interest rates to your financial situation and ways capture opportunities while mitigating risks.
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