As a consumer, it is important that you understand the dynamics of interest rate fluctuations. That's because the effects of rates rising or falling can impact everything from your mortgage payments to your investments.
How Interest Rates Are Determined
Interest rates are determined by the Federal Reserve Board, which meets on a regular basis throughout the year to review how the economy is performing. During slowing economies, or recessions, the Federal Reserve will lower interest rates to encourage consumer spending. When the economy is booming, the board may raise rates to capitalise on your spending and keep inflation in check.
Impact of Fluctuations
Interest rates are basically the finance charges that lenders assess when they make loans.
The rule of thumb in determining how you may be affected by changes in interest rates is as follows: when rates rise, your costs of borrowing do too. On that same note, when rates fall, your borrowing costs go down.
Effects on Mortgages
The mortgage industry represents one of the sectors that is sensitive to interest rate changes. Most affected are adjustable rate mortgages, also called ARMs. Borrowers of this type of mortgage can enjoy lower notes if interest rates decrease. However, if interest rates go up, so will their mortgage payments.
One of the reasons ARMs are attractive is because they allow borrowers to take advantage of falling rates without going through the refinancing process, according to Bankrate.com. Instead of having to pay a whole new set of closing costs and fees, ARM borrowers have the luxury of just waiting for rates to fall, along with their mortgage payments.
Rising interest rates can spell disaster for holders of ARMs because of the significantly higher mortgage payments they may have to pay. Over the course of the typical 30-year mortgage, higher interest rate environments are bound to occur. An ARM that starts with a 6 per cent rate can end up at 11 per cent in just three years if rates rise sharply.
Interest Rates and Investments
From a consumer standpoint, there are times when an interest rate increase can be good. That is especially the case when it comes to investments in products such as certificates of deposit (CDs), stocks and bonds. Investors enjoy interest rate hikes because it means a greater return on their investments.
Effects on Businesses
Because lower interest rates make it more affordable for consumers to borrow, they tend to spend more and that helps to boost the economy. The Federal Reserve Bank of San Francisco also points out that lower borrowing costs leads businesses to increase investment spending, and it leads households to buy durable goods, such as autos and new homes. In addition, lower rates can contribute to a bank being more willing to lend to businesses and households. This may increase spending, especially by smaller borrowers who have few sources of credit other than banks.