This is a guest post from RJ Knoll of WealthMaverick. See his bio below.
When most people think about what drives the economy, they think about common terms like supply and demand.
They think about the health of the stock market and the unemployment rate.
While these are undoubtedly important factors to consider, far too many people don’t understand how much of an influence interest rates play. In fact, nothing impacts the economy the same way these rates do and they’re almost entirely decided by a single group.
What Are Interest Rates?
In simplest terms, an interest rate is how much you’re charged for borrowing money. For example, if you borrow $100 at an annual interest rate of 5%, you’ll need to pay the lender $105 at the end of the year. That’s the price you pay – the interest of $5 – for the benefit of being able to spend money now that you otherwise wouldn’t have had.
On the lender’s side, they’re compensated for foregoing the ability to spend that money on something else. Interest also incentivizes them to take the risk involved as there’s no guarantee they’ll get their money back.
How the Fed Affects Interest Rates
Even if you never borrow a single penny in your entire life, interest rates will be one of the most important – if not the most important – economic factors that affects your finances.
That’s because the Federal Reserve is essentially lending the world U.S. dollars. So whenever you receive a paycheck, that money technically comes with an interest rate.
The Federal Reserve was created by Congress in 1913 for the purpose of stabilizing the economy. During the decades prior to its creation, there had been a run of “banking panics.” It has 12 regional banks and is run by a seven-person Board of Governors.
Among other things, the Federal Reserve provides cash reserves to U.S. commercial banks. It sets interest rates for borrowing money from it and a separate form for lending between banks. This latter amount is known as the federal funds rate.
As a guide for achieving economic growth and stability, the Federal Reserve may essentially change interest rates at will.
For example, following the most recent recession, the Fed introduced a policy of quantitative easing. They first dropped interest rates, making it cheap to borrow money and stimulating the economy. This can’t go on forever, though. Imagine what would happen to the value of the dollar if the amount of dollars in the world were to double or triple. Each would be worth less and our economy would crash.
With quantitative easing, the government first infused the economy with cheap money and then slowly raised interest rates over time. The idea was that doing so would eventually slow borrowing and restore stability but only after the economy improved.
Why Interest Rates Fluctuate
This, in essence, is largely why interest rates fluctuate. When the economy is trending downward, the Federal Reserve may buy up “bad debt,” which relives the institution of the burden and provides the economy with more cash – money that can be used to issue new loans.
Similarly, inflation causes interest rates to fluctuate, as well.
Inflation is the sustained increase in the general prices for goods and services. If your parent ever lectured you about how they used to go to the movies for 25 cents, the reason that’s changed is because of inflation.
The higher inflation rates go, the higher interest rates usually rise, too. That’s because lenders are thinking about the money they’ll be paid back in the future. If inflation continues to go up, the money they receive, say, next year is going to be worth a lot less. As such, they want to be compensated more to make up for this loss of purchasing power.
How Interest Rates Impact Consumer Debt and Real Estate
Interest rates can sometimes feel like nebulous forces. It’s not as though they fluctuate every day like the stock market.
For a better appreciation of how interest rates affect more than just the value of the dollar (which is already a huge impact), let’s look at three ways they affect the economy.
Secured debt is when a lender is provided collateral for their loan. A common example would be a mortgage. If the borrower doesn’t adhere to the terms of the loan, the lender can at least take ownership of the home and sell it to recoup their expenses.
Interest rates are generally lower for secured debt for this very reason. There’s less risk involved so the lender doesn’t need to charge as much to make the loan worth it.
That’s the bank’s interest rates, though. The Federal Reserve’s interest rates are still important because they affect the money supply. So even in the case of a mortgage, the interest a bank charges will fluctuate based on how much it costs them to borrow money from the Feds. While that collateral is still important, it doesn’t make it any cheaper for the bank to secure cash from the Federal Reserve.
Unsecured debt is the opposite. If you take out a personal loan because you want to pay off your credit card debt, you’ll find that the interest a lender charges you is more than they’d charge for the same amount if they were provided collateral.
That’s because they are far less likely of recouping their funds if the borrower defaults. They have nothing to sell off to make up for their losses.
Again, the Federal Reserve plays a role here. Interest will be significantly more for an unsecured debt if the Fed’s rates are high for the same reasons covered above and because of that lack of collateral.
There are a number of factors that affect how much commercial and residential real estate costs.
However, the Fed’s interest rates are, once again, particularly significant.
That’s because they affect mortgage rates and how much financing will cost. These amounts, in turn, affect properly-level costs, which go on to affect values.
Interest rates also impact capitalization and discount rates, which play an even bigger role in the cost of real estate. The former is the dividend rate an investor demands. A discount rate is how much an investor requires in returns.
The capitalization rate is the Required Rate of Return (RROR) minus the expected growth in income.
Each of these is influenced by current interest rates because they’re based on the combination of risk-free rates (decided by the U.S. Treasury and, thus, seen as unlikely to default) and risk premiums. The premiums adjust expected returns enough to decide whether or not an investment is worth it.
So while most people understand that mortgage rates affect the price of real estate, there’s obviously a lot more going on behind the scenes and each of these elements respond to the Federal Reserve’s monetary policy.
Beyond the cost of a new house, interest rates also determine how much capital is available to pay for them in the first place and what kind of demand there will be for investing. Property prices are largely decided by capital flows (supply of cash), which is completely controlled by the Fed.
Is Bitcoin Affected by Interest Rates
One of the most interesting – if not controversial – financial topics to emerge over the past decade has been Bitcoin.
Introduced back in 2009, Bitcoin is what is known as a cryptocurrency. This means it doesn’t have a physical form. It’s digital. The “crypto” portion refers to the fact that this digital money is encrypted.
Fans of Bitcoin point to a number of advantages, one of which is that cryptocurrency can be spent over the internet without the need of a middleman. This means paying far in less fees than you do by relying on a bank.
It also means that the Federal Reserve’s interest rates don’t quite affect Bitcoin.
As the Federal Reserve has no control over Bitcoin whatsoever, they can’t decide how much of it to supply to the economy. So while an independent party could charge interest to a borrower for Bitcoin they decide to lend, the type created by the Federal Reserve will never affect this currency.
That said, some experts have pointed out that the end of “easy money” could impact Bitcoin’s outlook indirectly. In short, as the Federal Reserve makes it costlier to borrow money, the opportunity cost for mining Bitcoins (the process of validating Bitcoin transactions and creating new ones) becomes more expensive.
Will that stop people from buying them?
Only time will tell.
For those who don’t trust the whims of the Fed, though, raising interest rates will only confirm the feasibility – and thus, value – of Bitcoin.
Utilizing an Understanding of Interest Rates
Those who don’t understand interest rates tend to summarize the way the economy works with two opposing forces: supply and demand.
While it’s definitely important to understand them, if you don’t keep an eye on what the Federal Reserve is doing with interest rates, everything from your investments to large purchases (e.g. homes) will suffer as a result.
However, now that you know about the influence interest rates play, you can make informed decisions and even do a better job of predicting how the economy will shift in the near future.
Who Is WealthMaverick?
RJ Knoll is the owner of WealthMaverick.com He writes all of the content using his past experience in personal finance and investing. WealthMaverick seeks to provide expert financial advice to help readers live the life they want regardless of their financial situations. You can read their Future Advisor review here.