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Interest Rates 101
POSTED: 10:40 am MST January 22, 2008
UPDATED: 2:18 pm MST January 22, 2008
It’s difficult for the average consumer to make sense of the various interest rates, and how changes in the rates might affect their personal lives.
We’ve assembled answers to some of the most common questions, as well as links to sources that can provide more extensive coverage of the topic.
Q: I’ve noticed that the interest rate mentioned in news reports is lower than the one I’m offered by my bank. What’s the difference between the two rates?
A: There are a number of different types of interest rates, and the rate depends on who is loaning the money and to whom.The first is the federal funds rate, which is the interest rate that one bank charges to another for borrowing cash reserves. This rate is the lowest rate you’ll see mentioned in news reports. It’s set by the United States Federal Reserve, which is the central bank of the United States.
The discount rate is another interest rate set by the Fed. This is the rate by which banks can borrow money directly from the Fed. The discount rate covers very short-term loans, usually overnight and is higher than the funds rate, because the Fed encourages banks to borrow from each other first.
There are three levels of the discount rate, and those are determined by the financial standing of the bank requesting the funds.
The Prime Rate is used by banks to set the benchmark interest rate for their loans. Most follow the average prime rate calculated by The Wall Street Journal. Think of this rate as a starting point for any loan you might receive from a bank.
A variable rate is tied to a certain index (such as the prime rate or Treasury Bills) and will change depending on the movement of the index it’s tied to.
More Info: Stock Market Glossary
Q: If I can’t borrow money at the low Federal Funds rate, why should I care if the Fed drops it or not?
A: While it sometimes takes a while for a change in the discount rate to show up in mortgages, it definitely has an impact on the average consumer. If the Fed lowers the federal funds rate, then banks can borrow money for less. The banks will then pass along that lowered rate to individual borrowers, which saves money for the average consumer.
More Info:How Soon Will It Hit Me?
Q: Okay, so why is a lower interest rate often seen as good for the stock market?
A: There are a couple of theories at work here. Investors assume that if individual consumers are able to borrow money for a car or home at a lower rate, they’ll feel as if they have more money. And in turn they will be more likely to spend that “extra” money on other consumer goods. That should be good for the economy, and indirectly, the stock market.
More Info: 10 Biggest Novice Investor Errors
Q: I have a feeling that there’s more to this than just investors “feeling good” about the economy.
A: Lower interest rates also have a couple of other impacts on the stock market and the economy. For example, the interest rate on U.S. Treasury bonds is closely tied to the federal funds rate. A drop in the funds rate lowers the interest rate paid on treasury bonds, making them less attractive to investors. That should make stocks a more attractive place to put your money. A lower fed funds rate also has some international implications.
A drop in the rate also decreases the value of the dollar on the foreign exchange market. That means the dollar is worth less if you’re traveling overseas, but it’s good news to U.S. manufacturers trying to sell goods overseas. The downside for U.S. consumers is that foreign goods will cost more, which means a potential price hike at your local department or toy store.
More Info: The Falling Dollar, Inflation And Your Retirement
Q: So what happens to bond rates when the interest rate changes?
A: Generally speaking, when interest rates drop, bond prices go down. It’s because institutions that buy bonds won’t pay as much for an existing bond that has a lower interest rate if the rate on new bonds is going up. A rise in interest rates has the opposite effect. And not all bonds are impacted the same way by changes in interest rates. Long-term bonds (ones that don’t mature for longer periods of time) gain the most when rates fall, or rise the most when rates climb.
More Info: What Exactly Is A Bond?
We’ve assembled answers to some of the most common questions, as well as links to sources that can provide more extensive coverage of the topic.
Q: I’ve noticed that the interest rate mentioned in news reports is lower than the one I’m offered by my bank. What’s the difference between the two rates?
A: There are a number of different types of interest rates, and the rate depends on who is loaning the money and to whom.The first is the federal funds rate, which is the interest rate that one bank charges to another for borrowing cash reserves. This rate is the lowest rate you’ll see mentioned in news reports. It’s set by the United States Federal Reserve, which is the central bank of the United States.
The discount rate is another interest rate set by the Fed. This is the rate by which banks can borrow money directly from the Fed. The discount rate covers very short-term loans, usually overnight and is higher than the funds rate, because the Fed encourages banks to borrow from each other first.
There are three levels of the discount rate, and those are determined by the financial standing of the bank requesting the funds.
The Prime Rate is used by banks to set the benchmark interest rate for their loans. Most follow the average prime rate calculated by The Wall Street Journal. Think of this rate as a starting point for any loan you might receive from a bank.
A variable rate is tied to a certain index (such as the prime rate or Treasury Bills) and will change depending on the movement of the index it’s tied to.
More Info: Stock Market Glossary
Q: If I can’t borrow money at the low Federal Funds rate, why should I care if the Fed drops it or not?
A: While it sometimes takes a while for a change in the discount rate to show up in mortgages, it definitely has an impact on the average consumer. If the Fed lowers the federal funds rate, then banks can borrow money for less. The banks will then pass along that lowered rate to individual borrowers, which saves money for the average consumer.
More Info:How Soon Will It Hit Me?
Q: Okay, so why is a lower interest rate often seen as good for the stock market?
A: There are a couple of theories at work here. Investors assume that if individual consumers are able to borrow money for a car or home at a lower rate, they’ll feel as if they have more money. And in turn they will be more likely to spend that “extra” money on other consumer goods. That should be good for the economy, and indirectly, the stock market.
More Info: 10 Biggest Novice Investor Errors
Q: I have a feeling that there’s more to this than just investors “feeling good” about the economy.
A: Lower interest rates also have a couple of other impacts on the stock market and the economy. For example, the interest rate on U.S. Treasury bonds is closely tied to the federal funds rate. A drop in the funds rate lowers the interest rate paid on treasury bonds, making them less attractive to investors. That should make stocks a more attractive place to put your money. A lower fed funds rate also has some international implications.
A drop in the rate also decreases the value of the dollar on the foreign exchange market. That means the dollar is worth less if you’re traveling overseas, but it’s good news to U.S. manufacturers trying to sell goods overseas. The downside for U.S. consumers is that foreign goods will cost more, which means a potential price hike at your local department or toy store.
More Info: The Falling Dollar, Inflation And Your Retirement
Q: So what happens to bond rates when the interest rate changes?
A: Generally speaking, when interest rates drop, bond prices go down. It’s because institutions that buy bonds won’t pay as much for an existing bond that has a lower interest rate if the rate on new bonds is going up. A rise in interest rates has the opposite effect. And not all bonds are impacted the same way by changes in interest rates. Long-term bonds (ones that don’t mature for longer periods of time) gain the most when rates fall, or rise the most when rates climb.
More Info: What Exactly Is A Bond?
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