What Interest Rates Measure:
How Interest Rates Are Determined:
As the housing boom accelerated, new types of variable interest rate loans were created. Some varied the rates according to a schedule. The first year was 1% or 2%, then the rate jumped in the second or third year. Many people planned to sell their home before the interest rate jumped, but some got caught when housing prices started to fall in 2006.
Even worse was the interest-only loan. Borrowers only paid the interest, and never reduced the principal. The worst was the negative amortization loan. The monthly payment was less than needed to pay off the interest. Instead, the principal on this loan actually increased each month.
Other Types of Interest Rates:
- LIBOR: This is the rate banks charge each other for overnight loans to meet the Fed's reserve requirements. It is an acronym for the London InterBank Offering Rate. It is usually just a few tenths of a point higher than the Fed funds rate.
- Prime Rate: What banks charge their best customers. It is usually above the Fed Funds rate, but a few points below the average variable interest rate.
- Credit Card Rate: This is usually the highest interest rate of all. That's because credit cards require a lot of maintenance since they are part of the revolving credit category. These interest rates are typically several points higher than the LIBOR rate.
- Non-revolving Credit Rate: These are typically consumer loans for automobiles, education and large consumer purchases like furniture. These interest rates are higher than the prime rate, but lower than revolving credit. Since these loans are typically one, three, five or 10 years, they vary along with the yields on 1-year, 5-year, and 10-year Treasury notes.
Why Interest Rates Are Important:
- If interest rates are increasing and the Consumer Price Index (CPI) is decreasing, this means the economy is not overheating, which is good.
- But, if rates are increasing and GDP is decreasing, the economy is slowing too much, which could lead to recession.
- If rates are decreasing and GDP is increasing, the economy is speeding up, and that is good.
- But, if rates are decreasing and the CPI is increasing, the economy is headed towards inflation.
How Interest Rates Affect the U.S. Economy:
Recent Interest Rate Trends:
The Interest Rate Outlook:Federal Reserve Chairman Ben Bernanke has said that the most important role of the Fed is to maintain consumer and investor confidence in the Fed's ability to control inflation. This means the Fed is always more likely to raise rates to prevent inflation.
On June 19, 2013, the FOMC announced it may start tapering its Quantitative Easing by the end of the year, depending on the strength of the economy. Specifically, this means that unemployment is headed toward 7% or the core inflation rate is more than the Fed's 2% target. The Fed funds rate will remain at zero until 2015. For more, see How High Will Interest Rates Go?.
How Interest Rates Affect You:The most direct impact interest rates have is on your home mortgage. If interest rates are relatively high, your loan payments will be greater. If you are buying a home, this means you can afford a less expensive home. Even if you are not in the market, your home value will not rise and could even decline during times of high interest rates.
On the other hand, high interest rates curb inflation. This means the price of other goods like food and gasoline will stay low, and your paycheck will go further. If you were smart enough to lock in a fixed-interest loan at a low rate, your income will stretch even more.
If interest rates stay too high for too long, it causes a recession, which create layoffs as businesses slow. If you are in a cyclical industry, or a vulnerable position, you could get laid off. (Article updated July 2, 2013)