If there is ever a time to start understanding how interest rates work, now might be it! The Bank of Canada, U.S. Federal Reserve and other central banks have been raising interest rates consistently since inflation has been rising rapidly as the pandemic ends, the war in Ukraine continues, and supply chain bottlenecks persist. Below is a simple explainer of what it means to cut rates and how it could affect you and your money.
What You Need to Know
What Is an Interest Rate?
Simply put, interest is the cost paid to borrow money, and the interest rate is the price. For example, a bank may agree to lend you $10,000 but only if you agree to pay them 5% interest per year on that $10,000, which amounts to $500. This is how lenders earn returns on their capital.
What is the Federal Funds rate? And why does it change?
Each country may use a slightly different term, but a baseline interest rate set by the central bank is the foundation for all other interest rates. The federal funds rate, also known as the target overnight rate, is the price to lend funds from the central bank to banks or between banks.
A central bank’s ability to change the target rate is used to stabilize or stimulate the economy.
For example. the government can raise interest rates when inflation is becoming too high as a way slow the economy and stabilize price increases. The idea is that the raised rates lessen the flow of credit into the financial system. These raised rates tend to discourage people from borrowing and spending, which in turn can slow inflation.
Alternatively, when growth is too low and unemployment is too high, the central bank can lower the target rate in hopes of encouraging people to borrow and spend, which increases the flow of money into the economy.
How Will Changes Affect You and Your Money?
Rate changes will affect anyone who has any debt. That means mortgages, lines of credit, credit cards…anything you pay interest on! This is important for mortgages; especially when rates go up. If you have a fixed rate mortgage, your rate will be unchanged until the end of the term, and then be adjusted, which will affect the size of mortgage payments.
The Bottom Line
The central banks had been using interest rate cuts to try to hedge against the economic impact of the pandemic; now they are utilizing rate increases to combat inflation. Discussing the impact of interest rate changes on your plans is recommended for all investors.