Interest rates are important for many aspects of personal finance, from how much debt costs to how much we can earn on savings and investments. Understanding how they work, who sets them and the effect on spending and savings is essential for people looking to take control of their finances.
When interest rates rise, the cost of borrowing increases and consumers and businesses may slow their spending. This is what the Federal Reserve hopes for when it raises rates: to cool consumer demand to prevent inflation.
But there are some positive effects of higher rates, too. Mortgage loans, for example, typically have lower interest rates than credit card or personal loan debts because the debt is secured by a property or cash deposit that a bank can use to reduce losses if the borrower stops paying. Also, as rates rise, savings accounts, money market accounts and CDs typically earn more. This is a welcome boost for savers, especially those saving toward a major goal like a home purchase or retirement.
As the economy strengthens, however, interest rates usually fall again. This may encourage consumer and business spending, but it also means that the returns from investment in stocks and other assets can decline. That’s why it’s vital to understand how to diversify your portfolio and to invest in low-cost options that don’t put a lot of risk on your back.
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