If you’ve considered taking out a loan or buying a home, you’re probably familiar with the concept of interest rates. Learning how changing rates impact your finances can help you define your next actions.
Impact on borrowing costs
Generally, higher interest rates make it more expensive to borrow money. The Federal Reserve sets the federal funds rate, which is the interest rate applied when banking institutions borrow and lend money to each other to fund their services. Raising the federal funds rate makes it more expensive for banks to borrow money to fund loans, slowing down the economy. These higher rates then apply to lending in other parts of the economy, too.
An example of interest rates affecting the broader economy is the housing market. Interest rates are applied as a percentage of how much a homeowner pays on their monthly mortgage payments. Having a low interest rate on your mortgage can make housing costs more affordable, whereas higher rates can push homes out of reach for some buyers.
Interest rates apply to other forms of lending, too, like credit cards and personal loans. Higher rates will mean you pay more in interest over the life of the loan, which can be particularly burdensome for those with credit card debt.
The good news is rising rates are usually a sign of a strong economy.
Inflation and consumer spending
If it sounds like high interest rates might keep you from some of your spending, that’s intentional: Higher interest rates are meant to slow down a hot economy. When it costs more to borrow money, consumers tend to spend less, take out fewer loans and increase their savings (more on that in a bit). The good news is rising rates are usually a sign of a strong economy.
For example, let’s look at inflation, or the increasing price of goods and services. If the economy is doing well and consumers are spending freely, prices may increase to align with that demand — which means inflation increases. When inflation rises too sharply, the Fed may raise interest rates to slow down consumer activity (and the rate of inflation).
Inflation is one of the major factors that the Fed considers when adjusting interest rates. Persistently high inflation can keep interest rates high. If you’re in the market for a loan, this can be frustrating. So try to remember these processes are in place to help maintain a stable economy.
Effect on savings and investments
When the Fed is using high interest rates to try to slow down the economy, they also want to incentivize saving.
Typically, when the Fed increases rates, banks will bump the yield they offer on savings accounts and various Certificates of Deposit. If you have a high-yield savings account like an Ally Bank Savings Account, you may see higher annual percentage yield (APY) when interest rates rise. This means you’ll likely earn more interest on your savings than if interest rates were low. As an added bonus, Ally Bank Savings Accounts also allow you to use tools like buckets and boosters to organize and automate your savings.
Interest rate increases may slow down activity in the stock market, too. If you want to hedge against inflation, diversifying your portfolio may help. But remember that rate adjustments likely indicate a changing economy. The overall economic picture and investor sentiment are also major factors in how the market performs, so there are no guarantees on how higher rates may affect stocks.
The bottom line on high rates
High interest rates can be frustrating, especially when rates stay elevated. But in a high-interest environment, you can pivot your financial priorities toward saving, planning and preparing for your next big milestone. After all, rates are always changing — so when the next drop comes, you’ll be ready.
