Understanding Interest Rates and Why They Change

By Tillie Allison | Updated: October 3, 2019

What Are Interest Rates?

The interest rate is the annual percentage of the outstanding loan amount that is charged as a fee for borrowing money. Interest rates determine how much money borrowers are paying, whether individuals, businesses, or governments and how much interest is earned by the lender, who may also be an individual, business or government. Higher interest rates mean it costs more to borrow money; lower interest rates mean it costs less.

Most everyone has had the experience of borrowing money and paying interest. In order to make more knowledgeable financial decisions, borrowers and lenders should understand why interest rates change and how the Federal Reserve Bank (“The Fed”) initiates those changes.

Animated image with The Fed building and hands pushing coins and bonds around.

The Federal Reserve Bank sets a “reserve requirement” for banks which is the minimum amount of cash they must keep on hand to meet the typical, daily, cash requirements of their depositors. The required reserve must either be in the bank’s vaults or on deposit at the local Federal Reserve Bank at the end of each day. If a bank does not have enough cash on hand to meet the reserve requirement, they must borrow money from The Fed or from other banks who have excess reserves.

Types of Interest Rates and Factors For Why Interest Rates Change

The Discount Rate

The discount rate is the interest rate that the Federal Reserve Banks charges commercial banks for short-term loans used to meet their reserve requirements. There are three discount rates offered by The Fed based on the bank’s standing. The primary credit rate is the lowest interest rate offered and is offered to banks that are generally more financially stable. The secondary credit rate is usually 50 basis points (1/2 a percentage point) higher and is for banks that do not meet the primary rate requirements. The seasonal rate is slightly higher yet and is used for small community banks that have more fluctuation in borrowing needs for farmers, student loans, resorts and other seasonal activities. The discount rate the bank gets will impact the interest rate they offer to their borrowers. The higher the discount rate the bank pays, the higher the interest rate a borrower is charged for a loan.

The Federal Funds Rate

The federal funds rate, which is also set by The Federal Reserve Bank, is the interest rate that banks charge other banks when they need to borrow money to meet reserve requirements. The Federal Reserve Bank meets eight times a year to set the federal funds rate.

Why is the Federal Funds Rate influential on other interest rates?

The Federal Reserve Bank influences these rates by manipulating the money supply. For example, when the government buys securities from banks, it increases the money supply for lending and decreases interest rates. When the government sells securities, it decreases the money supply for lending and increases interest rates. When the Federal Reserve bank wants to stimulate the economy, it can set lower interest rates. Raising interest rates increases debt owed and can cause an economic slowdown if debt ratios rise too quickly. The federal funds rate, then, impacts the interest rates for lending.

Inflation and Interest Rates

The Federal Reserve Bank monitors inflation and adjusts the interest rate to account for high or low inflation. When the inflation rate is higher, the Federal Reserve Bank is more likely to raise interest rates because higher inflation decreases purchasing power while higher interest rates offset the decline in purchasing power. For example, when Inflation rose 10% from 1971 to 1981, the federal funds rate rose from 5% to 13% from 1976 to 1980. In the 1990s, inflation and interest rates declined, with inflation ranging from 5% to 8% and interest rates from between 3% and 6% until the 2007 mortgage lending crisis. As of the date that this article is written, inflation is below 2% and interest rates are averaging 2.41%.

Types of Loans and Interest Rates

Interest rates also change depending on the type of loan. As mentioned, when banks lend their overnight reserves to other banks, that interest rate is determined by the Federal Funds Rate. For other lending products however, the 10-year U.S. Treasury bonds which are sold at auction, are used as a benchmark and guide for setting interest rates. Since Government Bonds are sold by the U.S. Treasury and are very low risk because the government guarantees the bonds, other types of loan risk is measured against U.S. Treasury Bonds. The level of risk will factor into the interest rate for loans.

Credit Risk and Interest Rates

A consumer's credit-rating (credit score) helps determine their interest rate when borrowing money. The borrower with a superior credit rating will qualify for lower interest rates while somebody with a poor credit history will pay higher interest rates because of the higher risk of default.

Similarly, bond credit-rating agencies evaluate the credit risk of corporate and municipal bond issuers. The lower the bond rating (B or C), the higher the risk that the issuer will default. The higher the bond rating (AAA, AA, or A), the lower the risk of default and the safer the investment. So, the higher the risk of default, the higher the interest rates for the bond and conversely, the lower the risk of default, the lower the interest rates for the bond.

Duration and Interest Rates

The duration of bonds and other loans will also factor into the interest rate being offered. Typically, longer term bonds or loans have higher interest rates and shorter term bonds or loans have a lower interest rate. With bonds, investors may refuse to invest for longer periods of time unless the interest rate is high enough to compensate them for tying up their money.

Adjustable (variable) interest rate loans are loans that have an interest rate that fluctuates based on the current interest rate environment. Upon maturity or expiration, a refinanced loan’s interest rate will be determined by any changes in interest rate (if the Federal Reserve Bank has changed rates), changes in the credit risk of the borrower and loan duration.

The Impact of Interest Rate Changes

Having a better understanding of why interest rates change can help borrower's get a lower interest rate on a loan as well as make smarter decisions concerning interest rate sensitive investments. By monitoring the Federal Reserve Bank’s rate changes, understanding how to determine the amount of credit risk when investing in interest paying investments and what role the duration of the investment plays as well as how an individual’s credit risk impacts ability to borrow money and at what cost, consumers can better understand the impact that interest rate changes will have on them and the economy.

About the Author
Tillie Allison

After graduating from the Online Trading Academy in 2006, Tillie Allison began to apply the rule-based core strategy to trade the financial markets. Tillie also gained trading experience working the trade desk at a futures firm. She is a passionate trader/instructor and teaches students how to identify low risk/high reward trades trading the rule-based core strategy.

This content is intended to provide educational information only. This information should not be construed as individual or customized legal, tax, financial or investment services. As each individual's situation is unique, a qualified professional should be consulted before making legal, tax, financial and investment decisions.

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