Understanding the Basics: Interest Rates

What Are Interest Rates?

Interest rates, in simple terms, are the cost of borrowing money or the reward for saving it. If you remember our past lesson on debt, we discussed a little bit about interest. However, you can use interest to your advantage by keeping money in the bank. For example, if you keep your money in the bank and the interest rate is 5%, you earn 5% on your initial investment. Think about it like keeping something for a friend. If you hold $5 for your friend, and you make them pay back $6, that's interest! The central bank, or the FED (Federal Reserve), controls the national interest rate of the U.S.

Why Do Interest Rates Change?

Interest rates change during times when the FED wants the general population to start spending money or stop spending money. When inflation is high, the FED usually makes rates higher. This makes people stop spending money because it is more efficient to stick your money in the bank and let it grow with a higher interest rate. On the other hand, when people aren't spending money, the FED lowers rates so people take their money out of the bank and spend it more.

What Is a Yield Curve?

A yield curve is a graph that shows how interest rates are expected to change over different time periods. The most common time periods used are 3 months, 2 years, 10 years, and 30 years.

Types of Yields

1. Normal Yield Curve: Long-term rates are higher than short-term rates, often indicating future economic growth.

2. Flat Yield Curve: Long-term rates are generally similar to short-term rates, often indicating economic uncertainty.

3. Inverted Yield Curve: Long-term rates are lower than short-term rates, often indicating a possible recession.

   
   

Yield curves are very important, as they are constantly watched by economists, investors, and the FED. Prior to some past recessions, the yield curve was inverted.

Housing Market and Interest Rates

When buying a house, someone most likely takes out a loan called a mortgage to help pay off the house. What's special about a mortgage is that it comes with an interest rate. The higher the rate, the more expensive it is to take out the loan. Let's say you borrow $100,000 for a house with a mortgage rate of 3% paid over 30 years. You'd end up paying over $152,000 for the entire house after 30 years.

When rates go up, fewer people can afford the expensive loans, so the housing market drops. When rates go down, more people can afford the cheaper loans, so the housing market rises.

Rising mortgage rates also affect investors and builders. Rising rates make the cost of building neighborhoods more expensive, which can increase housing shortages.

---

Comment if you think interest rates will fall soon!