How Interest Rates Affect Your Portfolio and the Overall Economic Situation
Interest is the price you have to pay to borrow money. The interest rate is what that price is.
Lenders charge interest because they can’t just give the money away. They have to make a profit to stay in business. So when you borrow, you have to repay the loan amount plus an additional amount charged by the lender – interest – for the use of their money.
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The interest rate you will have to pay will depend on various factors. It is important to understand these factors as well as the impact of interest rates on the amount you pay to borrow and their impact on the overall economy.
How Interest Rates Work
Interest rates are expressed as a percentage. If, for example, a loan has an interest rate of 5%, that means you have to pay the lender back the amount you borrow (the principal) plus 5% of the principal.
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The length of time you borrow money is also factored into the equation. Simple interest is equal to the principal x rate x period of time. So if you borrowed $ 1,000 at 5% for one year, the calculation would be 1,000 x 0.05 x 1. The interest you would pay would be $ 50 and the total you would pay back to the lender would be of $ 1,050.
It can get a bit trickier than that, however. Simple interest means that interest is charged only on the principal. Compound interest is interest calculated on the principal plus accrued interest. It is important to know if the interest on a loan is compounding and how often (daily, monthly, annually) as this will affect the total amount you will have to pay over time.
You should also pay attention to the annual percentage rate (APR) when you borrow money. The APR includes the interest rate charged plus any additional fees charged by the lender – so it reflects the total cost of the loan.
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What determines interest rates
The interest rates that lenders charge consumers are heavily influenced by the rates set by the Federal Reserve: the federal funds rate, the discount rate, and the reserve rate. The federal funds rate is the most influential because it is the rate that banks charge for overnight loans.
Many banks set their prime rate – the base interest rate they use for commercial loans and certain consumer loans and lines of credit – based on the target range set by the Federal Open Market Committee for the rate. federal funds. The prime rate is only a starting point, however, as are the other benchmarks used by banks to set rates. Lenders consider other factors when setting interest rates:
Creditworthiness of the borrower: Lenders will check your credit rating and credit history, which will show them how responsible you are when it comes to managing credit. The more creditworthy you are, the lower your interest rate will be.
Duration and amount of the loan: Shorter, smaller loans tend to have lower interest rates than larger, longer-term loans.
Deposit amount : Some loans such as mortgages and auto loans usually require a down payment. Making a large down payment (like 20% or more on a home) can help you get a lower interest rate because it signals lenders that you’re at less risk.
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How interest rates affect you
If you are borrowing money, it is important to be careful about the interest rate you have to pay. The higher the rate, the more you will have to repay the lender. That is why it is a good idea to avoid accumulating high interest debt like credit card debt. The more interest you have to pay, the less you will have to pay for the things you need and want.
On the other hand, a high interest rate can be beneficial if you earn it on money that you put in a savings account or that you have invested. If you invest for retirement, a higher rate of return will help you reach your retirement savings goal faster.
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How Interest Rates Affect U.S. Financial Markets
Interest rates don’t just affect what you have to pay to borrow money, they also affect the economy and the stock and bond markets. Lower interest rates tend to promote economic growth, as households can borrow more money to make purchases and businesses can borrow more to expand their businesses. Higher rates, on the other hand, tend to slow economic growth.
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Interest rates have no direct impact on the stock market. Stock prices can go up or down during times of rising interest rates. However, there is a direct correlation between changes in interest rates and bond prices. When interest rates rise, bond yields rise and bond prices fall. When rates fall, bond prices rise.
Because interest rates affect so many aspects of the economy, they are one of the most watched economic indicators. You should also watch them closely, as they can greatly affect your personal finances.
This article is part of GOBankingRates’ âEconomy Explainedâ series to help readers navigate the complexities of our financial system.
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Last updated: February 22, 2021
This article originally appeared on GOBankingRates.com: How Interest Rates Affect Your Portfolio and the Overall Economic Situation