😰 Interest rates got you sweating?

Interest rates have the ability to either feel like a personal attack on your finances or free money–giving them the ability to evoke two very different responses.

The interest rate on your credit card? Yikes. The interest rate on your high yield savings account? Great news.

WHY INTEREST RATES MATTER

In short, they matter because they directly impact the money either going into or coming out of your pocket. They can determine how long it takes to pay off your student loans, how much it will cost to buy a car, how quickly you’ll have enough saved to take a long weekend away, and even how much income your portfolio throws when you reach retirement.

HOW INTEREST RATES WORK

Interest rates are the price tag for borrowing money. When you use a credit card, you pay the price tag for the opportunity to borrow money upfront with the option to pay it back over time. When you put money into a high yield savings account, the bank is paying the price tag to borrow your money (yeah, they don’t actually keep it all sitting around waiting for you). Boom. Easy as that.

So a high price tag (ie interest rate) is great when a bank is paying you. Not so great when you’re paying your credit card company.

Wealthfront sums it up well, “When borrowing money, rising interest rates will cost you more in the long run. When saving or investing, rising interest rates will earn you more cash over time.”

While we’re at it, you should know the difference between simple and compound interest. Simple interest earns a percentage based on the principal amount, aka what you put in the bank. Compound interest earns interest on top of interest + principal and can be compounded monthly, quarterly, annually, etc.

For example, if you put $1,000 in an account, your principal is $1,000. If you earn 5% interest on that account for 10 years, at the end of 10 years, you’d have $1,500. If you earn 5% interest, compounded annually, at the end of 10 years, you would have $1,628.89. While $100 and some change over 10 years may not seem like much of a difference, imagine you continually adding to that original principal and putting in $1,000 per year over 10 years. Oh and let’s say it’s earning compound interest over 30 years instead of 10.

Here’s a calculator you can play around with.

WHY INTEREST RATES CHANGE

The Federal Reserve, America’s central banking system, sets the interest rate that banks charge each other to borrow money. Banks then use that rate to establish the interest rates they give or charge to their customers.

A quick lesson in supply and demand here explains why interest rates change over time. Rates are reflective of both the demand from borrowers and the supply of funds available to be loaned. Finpipe calls interest rates, “the price of money.”