How do interest rates work?

A change in short-term interest rates can affect your savings accounts, investment portfolio, and more.

Interest rates help determine both the cost of borrowing money and the reward for saving money. Higher or lower interest rates can have ripple effects throughout the economy, including on your investments.

Let’s dive into how interest rates work, what causes interest rates to rise or fall, and how they affect your savings and investments.

What is interest?

Interest is a term that can refer to both the cost of borrowing money and the return earned on an investment.

When you borrow money from a financial institution, you’re obtaining a loan in exchange for a small fee, which is the interest you pay to the financial institution. And when you invest money in a savings account, bond or other money market product, interest is the return you receive on your investment.

There are two main types of interest: simple and compound. 

• Simple interest: With simple interest, the interest is calculated only on the principal (original) amount of the investment or loan. This means that the interest you pay (or earn) remains the same each period.
• Compound interest: Some investments offer compound interest, where the interest earned in one period is added to the principal investment, and then interest is calculated on the new total. In other words, the interest you earn compounds over time, leading to potentially higher returns, especially if you have a longer investing timeline.  

What are interest rates?

The interest rate is the percentage that dictates how much interest you’ll pay or earn on a financial product.

A higher interest rate means you’ll pay more to borrow money or earn more on an initial investment. A lower interest rate means you’ll pay less to borrow or earn less interest on your investment.

Interest rates on a financial product can be higher or lower based on several factors.

One factor is the Federal Reserve’s (the Fed) monetary policies. While the Fed doesn’t set all interest rates, all interest rates are influenced by the Fed’s target federal funds rate and other policies. (More on how this works below.)

There are also personal factors that influence the interest you pay on a loan, mainly your “creditworthiness.” A bank or other entity may look at your FICO credit score, bank statements and other financial documents before deciding what interest rate to offer you. If you have a good credit score, for example, you may be viewed as more likely or able to pay off your debt and therefore qualify for a lower interest rate.

Interest rates can also be fixed or variable. 

• Variable interest rates can change over the length of the loan depending on market conditions, meaning if you take out a loan, your payment may increase or decrease at different times.
• Fixed interest rates  are locked in for the length of a loan and cannot change.  

Common types of loans and their interest rates

• Mortgages and auto loans typically have fixed interest rates. There are also a small number of home mortgages called adjustable-rate mortgages (ARMs), which means the interest rate can fluctuate throughout the length of the loan. That said, ARMs often have a period of fixed interest before they can fluctuate.  
• Credit cards and home equity lines of credit (HELOC) often have variable interest rates, meaning the amount you’ll pay each month may vary based on market conditions. Variable interest rates may be beneficial when interest rates are declining, but when interest rates rise, you’ll pay more. Variable interest rates can also make it harder to budget, as you won’t have a set amount to plan for each month.
• Student loans. Student loans are usually fixed-rate loans, but if you apply for a private student loan, you may be offered a variable rate.  

What causes interest rates to rise and fall?

The Fed sets a target range for the federal funds rate, which is the rate banks charge each other for short-term loans. The Fed also sets the discount rate, which is the interest rate banks pay when they borrow directly from the Federal Reserve.

While neither of these is the same as the interest rate you’ll pay on a loan, the target federal funds short-term interest rate influences it.

Reasons the Fed might use its monetary policy to influence interest rates include:

• Raising interest rates can combat inflation and calm the economy. When the economy is growing quickly, the Fed may become concerned about inflation or other issues of too-fast economic growth. In this case, the Fed can pump the brakes and increase the target federal funds rate. With higher interest rates, businesses may borrow and invest less due to higher lending costs and potentially stop hiring, which may reduce consumer spending as incomes fall. 
• Lowering interest rates can stimulate the economy. If economic growth is lagging and unemployment is rising, the Fed can lower interest rates to make it cheaper to borrow money. The intent is to spur businesses to invest in projects and hire employees to fulfill projects, which in turn should increase consumer income and spending.

How does raising interest rates help inflation?

When it comes to the Fed’s influence on interest rates and how raising interest rates can help inflation, it’s important to understand that the Fed has a triple mandate: to promote maximum employment, moderate long-term interest rates and stabilize prices.

When prices are rising more quickly than the Fed’s target 2% annual rate of inflation, the spending power of consumers and businesses decreases, which in turn destabilizes the economy and puts the triple mandate at risk.

To cool inflation, the Fed may use its influence to raise interest rates. Higher interest rates make it more expensive to borrow, meaning that consumers and businesses will be less willing to spend money. This decreases demand, theoretically bringing prices down.

Understanding how, and when, the Fed changes rates can help you address any impact on your investment portfolio. Stay up to date on the latest Fed interest rate changes.

How do banks set interest rates?

A bank will usually use the Fed’s target fed funds rate to set its own prime rate, which is often, but not always, the amount of interest you’ll pay on a loan.

Banks often follow the “fed funds plus three” formula. So, if the fed funds rate is 5.25%–5.50%, the prime rate tends to be about 8.50%.

However, a bank could adjust the interest rates on its loans according to supply and demand, an individual borrower’s creditworthiness or other factors. 

Interest rate impacts on bonds

Interest rates and bonds have an inverse relationship: When interest rates rise, bond prices fall, and vice versa. Newly issued bonds will have higher coupons after rates rise, making bonds with low coupons issued in the lower-rate environment worth less.

It’s helpful to understand the following three concepts regarding the bond and interest rate relationship.

• Paper yields and paper losses: Imagine you purchased a bond for $1,000 (the par value). If the Fed raises the interest rate, this may decrease your bond’s market value to $900. In this case, the paper loss is $100 — but as the name implies, this loss is only on paper or may be the price you receive if you sell it. If you hold this bond to maturity, you should still receive 100% of its original par value, unless the issuer defaults.
• Fluctuating interest rates and market rates: When interest rates fluctuate, the market rate of a bond fluctuates along with it. But not all bonds are affected equally: Bonds with shorter maturities may be less affected by interest rate fluctuations, while bonds with longer maturities will generally incur a greater paper loss.
• Short-term changes vs. long-term outlooks: Short-term interest rate changes should not affect your long-term outlook if you have a longer time horizon and an appropriate mix of stocks and bonds (balanced portfolio). Bond price decreases will likely be offset by bond price increases at a later date. Staying the course and diversifying can help to preserve your overall investment portfolio against the effects of changing interest rates in the long term.

Read more about how interest rates affect the bond market.

Interest rates and stocks

In contrast to bonds, stock prices are not directly affected by interest rate changes.

When interest rates rise, banks often increase loan costs for consumers and business loans, which can reduce spending and lower stock values. Higher interest rates may lead companies to halt business expansions and put a pause on hiring.

There’s no guarantee that an interest rate change will affect stocks, however. With a balance of stocks and bonds, your portfolio may be better positioned to maintain more stability despite a change in interest rates.

Read more about the current impact of rising interest rates on the stock market.

Interest rate impacts on savings and other investments

It’s smart to consider how rate changes might affect elements in your portfolio other than stocks and bonds.

• You may hold savings accounts and certificate of deposits (CDs) as a buffer for more volatile investments like stocks. An increase in the Fed’s interest rate may lead to an increase in the annual percentage yield (APY) on CDs and savings accounts. Therefore, CD and savings account rates are generally more favorable after an interest rate hike and less favorable after a cut.
• Commodity prices may fall when interest rates rise, suggesting that an interest rate hike sometimes creates an unfavorable climate for these investments, and vice versa.
• If you have holdings in real estate, an interest rate hike can be detrimental, while a cut can be beneficial. Real estate prices are closely linked to interest rate markets, in part due to the cost of financing (mortgage rates) and in part due to some bond-like characteristics, such as regular income payments. Like bonds, the relatively steady stream of income that real estate generates becomes less attractive as interest rates and coupons on newly issued bonds rise.

Summary: How do interest rates work?

In summary, here’s how interest rates may affect different accounts and investments:

Because interest rate fluctuations can affect your savings and investments in different ways, there is no single action you should take when they change.

Stay focused on your financial goals, stick to your plan and work with your financial professional to construct a portfolio that is diversified enough to help weather any short-term effects of an interest rate change.

Your financial plan should reflect your goals, risk tolerance and time horizon. Learn how our approach to financial planning can help you achieve your vision of success.