I was running through my normal Google alerts yesterday and saw a headline that said, “Do interest rates matter?”
My answer is an emphatic YES!
Of course, interest rates matter. It determines how much you pay and how much you get paid!
When you borrow
Whether you’re talking a mortgage, an auto loan, a business loan, or a credit card, you are charged an interest rate when you borrow money.
For example, the average mortgage rate right now is a shade under 4.5%. In 1981, that same rate got to over 18%. To put these numbers into context, here’s a comparison of the same mortgage with different rates.
Loan amount $250,000. Interest rate 4.5%. 30-year fixed rate. Monthly payment – $1,266.71. Total amount paid after 30 years – $456,015.60.
That same mortgage with an 18% interest rate translates into a $3,767.71 monthly payment, and a total amount paid after 30 years – $1,356,375.60.
Obviously, these are extreme examples, but you get my point.
Just 3 years ago, mortgage rates were a full percentage point lower, until the Federal Reserve started to increase interest rates.
The same goes for credit cards. That 18% mortgage rate from ‘81 is close to the average credit card interest rate today. If you’re using credit cards to buy things you can’t afford, you’re definitely paying for it.
When you save
If you are responsible with your money and are able to save it, you should be rewarded for that behavior. Interest rates are creeping higher now, but a year or two ago you were getting paid next to nothing on your savings account.
When interest rates increase, so does the money you earn from your savings.
The Federal Reserve
The FED sets the tone. They raise or lower the Federal Funds Rate and that has a ripple effect on all the other interest rates in the financial system.
They have a tough job, as you can see currently because they have to raise rates enough to keep inflation at bay but keep them low enough as not to cause a recession.
You see, when the FED raises interest rates, all rates that are classified as variable (on existing debt) go up. The most common example is credit cards. As credit card rates increase, so does the cost of servicing those outstanding balances (minimum payments go up).
As people’s debt gets more expensive to service, the number of defaults (failure to make adequate payments) goes up. This will create a domino effect and can bring the economic system to a halt.
This is similar to what happened in 2008, although on a much larger scale. And 2008 wasn’t caused by frivolous spending, it was caused by finance executives giving mortgages to people who couldn’t afford them, as well as signing poorly structured loans that were affordable in the beginning, but became unaffordable a short while later.
Approaching recession
When The Great Financial Crisis happened, the FED lower interest rates to 0%. This encouraged financial institutions to lend money, and incentivized businesses and individuals to borrow money.
People who borrow, spend, and people who spend help grow the economy.
Here’s our current problem. The Federal Funds Rate is currently at 2.5%. When the economy experiences a recession, in order to encourage borrowing and spending to get the economy out of the recession, the FED needs to cut rates by at least 4 percentage points (I got this number from Dr. James Rickards).
The Trump Administration and other parties are calling for the FED to cut rates to continue the current expansion.
The only problem is this expansion will have to come to an end at some point, and when it does (if rates don’t increase) the FED won’t be able to cut rates enough to help the economy.
Conclusion
I’ll say it again. Interest rates matter.
If you’d like to learn more about this topic and for my disclosures, please visit CRG Financial Services.
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