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What are interest rates?

Interest rates are good when you’re saving and not so beneficial when you’re borrowing. But what exactly are interest rates, how do interest rates work, and how can you use that to benefit your financial plan?

What are interest rates?

The short version: Interest rates are the price of money.

  • You pay interest on loans because the bank or credit company that provides the money must pay for its expenses.
  • You are paid interest on savings because the bank or credit company must pay you to use your money.

How does the process work? Let’s say you need to buy a car, so you visit a local bank for a loan. They set an interest rate to charge you. But the bank needs to get access to funds of their own in order to be able to lend you (and others) money.

Banks and other financial institutions borrow (and lend to each other) all the time. The interest rate they pay is a little lower than yours, and it’s set by the Federal Reserve. When a bank charges you a higher interest rate than they paid, the increase helps make up for the costs in lending money.

How interest rates get from the Fed to you

The rateWhat it isHow it affects your budget
The federal fund primary rateRate that banks charge one another to borrow or lend excess cash reserves overnightDecreases equal a cheaper cost to borrow money. Increases mean the opposite.
Bank-to-bank rateRates that banks nationally and globally use to lend to one anotherIt doesn’t; this is what financial institutions charge one another.
Consumer borrowing rateRate that financial institutions charge consumers for loans—mortgages, car loans, etcWhen the primary rate goes down, these rates go down, too.
Consumer savings rateRate on easily accessible options such as traditional savings accountsWhen the fed rate goes up, savings account rates go up.

How interest rates work for loans and savings

If you have a big purchase such as a house or car on the horizon, you might like when interest rates are low, because you can get a loan at a low rate. The consumer rate varies from one financial institution to the next, and even a quarter of a percentage rate can make a big difference in your monthly payment, especially over the life of a longer loan.

But for your savings accounts, you’d like interest rates to be higher so you earn more on that money.

See the chart below for a quick summary.

Interest rate on a …Stated asWhen it’s higherCompare
Loan or credit% of amount borrowedMoney you borrow is more expensive.Upfront costs, such as origination and other fees; set or variable interest rates
Savings or checking accountAnnual % yields, or APYMoney you save earns more.Fees, withdrawal terms, and minimum required balance

How interest rates can help you with financial decisions

You can’t control interest rates. But you can control how much you’re borrowing and saving—and try to strike a balance between the two—so that you minimize what interest rates cost you and maximize how much you’re able to earn with them.

Savings or investment products and interest

Interest may be stable but lowerInterest may be variable but higher
Checking accountsSome online savings accounts
Traditional savings accounts
Certificates of deposit
Bonds

For example, you can shop around for better interest rates on big-ticket items. If interest rates are low, it may also be time to consider purchases you’ve been saving for, too.

Conversely, if you have some savings goals, you can research accounts with potential higher return. The tradeoff on the latter is that accounts with the potential for higher earnings change rates more often—and therefore come with more risk.

Whether you’re putting money away or setting your sights on a big purchase, thinking about interest rates and how they impact your goals can be a helpful way of avoiding unwanted expenses and maximizing what you earn.

Next steps

Insurance products and plan administrative services provided through Principal Life Insurance Co. Securities offered through Principal Securities, Inc., member SIPC and/or independent broker/dealers. Referenced companies are members of the Principal Financial Group®, Des Moines, IA 50392.