If there is ever a time to start understanding how interest rates work, now might be it! The Bank of Canada, U.S. Federal Reserve and other central banks have been raising interest rates consistently since inflation has been rising rapidly as the pandemic ends, the war in Ukraine continues, and supply chain bottlenecks persist. Below is a simple explainer of what it means to cut rates and how it could affect you and your money.
What Is an Interest Rate?
Simply put, interest is the cost paid to borrow money, and the interest rate is the price. For example, a bank may agree to lend you $10,000 but only if you agree to pay them 5% interest per year on that $10,000, which amounts to $500. This is how lenders earn returns on their capital.
What Is the Federal Funds rate? And why it changes?
Each country may use a slightly different term, but a baseline interest rate set by the central bank is the foundation for all other interest rates. The federal funds rate, or the overnight rate is the price to lend funds between banks or to banks from the central bank.
A central banks ability to change the target rate is used to sway the economy in two major ways:
- The first is inflation. The government can raise interest rates when inflation is becoming too high as a way slow the economy and stabilize price increases. The idea is that the raised rates lessen the flow of credit into the financial system. These raised rates tend to discourage people from borrowing and spending, which in turn can slow inflation.
- The second is to stimulate the economy. This is when growth is too low and unemployment is too high. By lowering the rates, the central banks hope to encourage borrowing and start a flow of money into the economy.
How Will Changes Affect You and Your Money?
Rate changes will affect anyone who has any debt. That means mortgages, lines of credit, credit cards…anything you pay interest on! This is important for mortgages; especially when rates go up. If you have a fixed rate mortgage, your rate will be unchanged until the end of the term, and then be adjusted, which will affect the size of mortgage payments.
Variable vs. Fixed Rates
It's important to understand variable rates and fixed rates. Fixed rates are based of the bond market and variable rate mortgages change based on the central bank (Bank of Canada). This is an important difference because ultimately, what happens with rates is that bond market tries to forecast what is going to happen going forward and the central bank changes interest rates based on what does happen. When the media talks about interest rates, rarely to they communicate the difference so it's not uncommon for homeowners to stress out at the wrong time.
The Bottom Line
The central banks had been using interest rate cuts to try to hedge against the economic impact of the covid-19 pandemic, now they are utilizing rate increased to combat inflation.
Discussing the impact of interest rate changes on your plan is recommended for all investors.
