What Happens When Interest Rates Change?

In early August, the Federal Reserve announced that they were cutting federal fund interest rates by 0.25%. This is the first interest rate cut in over a decade. The federal fund interest rate is the rate that financial institutions charge each other when they borrow money short term. (Yes, even banks borrow money!) A change in the federal fund can, in turn, affect consumer interest rates. This may leave you with questions about why interest rates change and what happens when the Fed lowers interest rates.

Why Do Interest Rates Change?

A quarter percent change in interest rates may not seem like it would have a great financial impact, but you’d be surprised what this small change can evoke. Here are the factors that the Fed takes into consideration when they decide to increase or decrease interest rates.

Economic Growth — One of the main reasons that interest rates change is simple supply and demand. When economic growth is healthy, more people are looking to borrow money (to buy houses or new cars). In turn, lenders need to have funds available and will raise interest rates to keep a steady stream of money coming into their institutions. When economic growth slows, like in a recession, there are fewer borrowers and lenders typically cut interest rates to stimulate demand.

Monetary Policy — Central banks, like the Federal Reserve, at times will alter the overall money supply in the U.S. to control inflation and manage the economy. They can “create more money” by depositing more money into commercial banks. This will cause banks and credit unions to lower interest rates because they have more funds available. On the opposite end, they can also withdraw funds from financial institutions, which cause rates to rise.

Inflation — Inflation is the price of the goods and services you purchase. As inflation rises, you spend more for the same things and your dollar has less purchasing power. During times of high inflation, interest rates will also rise. Lenders will charge more interest now because the money they will be repaid in the future will have less purchasing power.

What Happens When Interest Rates Rise or Fall?

budget planning when interest rates rise or fall imageHow is your money affected when interest rates fall, as they have recently? Different financial initiatives are impacted in different ways. Here’s a snapshot of what you may see in the near future.

Savings Account — When interest rates drop, traditional savings accounts can suffer. However, you can take advantage of this rate change by exploring high-yield savings accounts instead. While the interest rates for money market deposit accounts and share certificates will also fall, they still provide higher interest rates than traditional savings accounts. If you can set money aside and not access it for several months, these may be better savings options.

Buying a Home — If you’ve been on the fence about buying a new home, falling interest rates may be the sign you’ve been waiting for! Here’s how much you can save by taking advantage of a lower interest rate:

With a 30-year mortgage of $200,000 at 4.5% interest, you’d have a $1,013.37 monthly principle and interest payment. At 4.25%, your monthly payment drops to $983.88. Over 30 years, you’ll save nearly $11,000 from your lower interest rate.

When interest rates drop, it’s also a great time to refinance the mortgage on your home if you’re currently paying an unfavorable interest rate.

Credit Card Spending — Like a mortgage, a credit card can carry either a fixed rate or variable rate. If your credit card has a fixed rate, then you won’t see any impact when the Fed lowers interest rates. With a variable rate card, you may eventually see an interest rate drop. However, credit card issuers can use the highest interest rate in effect over the previous 60-day period, so it may take a month or two to see the benefits of a lower interest rate.

Interest rate changes typically prompt individuals to re-evaluate their finances. The team at Diamond can work with you to ensure you’re financially sound.

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diamond university logoThis article is part of Diamond’s ongoing financial education program.

The views, opinions, and ideas articulated in this blog are just that, and should not be construed as financial or legal advice. The writers of these blogs are educated on the topics they are writing about, but they are in no way licensed financial advisors or registered investment advisors. Diamond Credit Union is not responsible for any actions a person may take as a result of the information they read in one of our blogs.