Interest Rates Explained Incredibly Simply

Interest Rates and How They Affect You Directly

Trading Room Watching Financial News
••• Andrew Burton

Interest rates are one of the most common topics when it comes to investing and the economy, but also the least understood by the masses. With this week's first rate increase in the last nine years, the Federal Reserve (FED) decision has been front and center the world over.

The interest rate dictated by the FED has significant ramifications on all aspects of your economic life, from the strength of your currency to the amount you pay for your monthly car loan. I explain many of the ways this will affect you directly in this short video, but simply put, the higher the rate, the more you will pay for any loans or credit.

The chart below illustrates the changing Federal funds rate from the year 2000 through the present.

With this week's 1/4 of a percentage increase in the interest rate, banks now can charge 1/4 of a percent more for floating rate mortgages, loans, and lines of credit. It doesn't sound like much, and certainly nothing justifying the amount of media coverage on the topic in the financial news, but the FED may raise the interest rate a few more times in 2006, and beyond.

Once all these 1/4 and 1/2 point rate adjustments add up, you may start to feel the effects. The FED has indicated that they may potentially reach a full percentage point higher next year, and then go further depending on the health of the economy.

Another consideration is the potential for inflation after trillions in money printing. Typically inflation can be battled with interest rates, as long as the level of those rates is higher than the level of the inflation. In other words, 11% inflation can be quelled with 13% interest rates... We are purposely getting many years ahead of ourselves with this example, but it was used to explain the concept.

Higher interest rates mean that:

  • it will cost billions more for America to pay the interest on their outstanding debt
  • it becomes more costly for other nations, indebted to America, to pay back what they owe
  • bond and IOU prices typically fall (because higher yield from new debt instruments reduce the comparative return from pre-existing bonds)
  • unless they are locked in, you pay more for credit cards, mortgages, loans, lines of credit, and car payments
  • banks can charge more interest (although they have welched so far in terms of paying more for the savings in the bank)

You may also see the US dollar rise in value, compared to other currencies, and the commodities which are priced in American dollars (such as gold, oil). The higher the rates on our cash, the more return other nations will attain by purchasing US bonds and debt.

Best case scenario, you limit debt and maintain a good cash position to take advantage of opportunities as they arise. For example, if rates get higher quickly (as in a couple percent over a year or so), many people will not be as capable to afford their debts. 

If such a scenario results in people selling their houses, or not buying quite as elaborate/expensive of homes, there may be a glut of supply. With any inflated supply, prices will come down, and that fancy car or beautiful home you have your eye on may be selling for much less in a year or two from now.