Demystifying Interest Rates

Title: Demystifying Interest Rates

The headline on the front page of the Wall Street Journal on April 26, 2024 was about the U.S. economy and the previous day’s GDP (Gross Domestic Product, the primary indicator of economic growth) report from the Department of Commerce. There were no fewer than six references to the term “interest rates” scattered across roughly 700 words.

Conceptually, we all understand what interest rates are, but why are they so important? As an individual, why should you care and how should you think about them?  Before we answer these questions, let’s take a break from the practical and jump into the theoretical.

Economics is a social science that examines scarcity and how scarce resources are produced, distributed, and consumed in society.  Finance is the corner of economics that concerns itself with money in all its forms: savings and investments, borrowing and lending, capital markets, etc.  But money, like all resources, also has a scarcity dynamic. Interest rates are the mechanism by which the scarcity (i.e., the supply & demand) of money is expressed.

Money is unique among all resources in that everyone, no matter who or where, either has it (and has to figure out what to do with it) or needs it (and has to figure out how to get it).  As a result, money has both a cost (for those who need it) and a reward (for those who have it).  Interest rates indicate how much that cost or reward will be.

You will frequently hear  terms and references from banks and other financial institutions, such as “rates,” “yield,”and “APR.” But the math of interest rates is straightforward algebra and always includes the same variables: 1) the percentage rate that you get paid or are charged, 2) the amount of money that the rate applies to, and 3) the time period that the rate will be in effect and the frequency that you will pay or be paid the stated rate.  

CTA button:  Want a more detailed explanation of the dynamics of money and interest rates? Register for the Litmus Finance 101 Bootcamp.

There are many types of interest rates.  Let’s take a closer look at some of them and their importance in financial markets and personal finance. 

Federal Funds Target Rate (also known as  “Fed Funds”): the Fed Funds rate is set by the Federal Open Markets Committee (FOMC).  The FOMC is the monetary policy-making body of the Federal Reserve, the U.S. central bank.  The Fed Funds rate is set in a range of ¼ of one percent and currently stands at 5.25%-5.5 Practically, it is the overnight rate at which banks lend money to each other in order to balance their required reserves.  

It also serves as a reference point for other rates that banks use, such as the rate they pay to customers on the balances in their checking and savings accounts (also known as demand deposits) and the rates charged by banks for loans (see more on Prime Rate below). Fed Funds also influence the prevailing rates in the market for U.S. Treasuries (government debt issued as bills, notes or bonds by the Department of Treasury; see more in our separate note on The Yield Curve, link below), which are themselves important reference points for various borrowing costs in other markets.

Since the Fed Funds Rate sets the tone for other interest rates, it is easy to see why it is an important number to individual companies and stock markets alike. Companies (and by extension, their shareholders and investors) care because it dictates their cost of loans and other financing.  Falling rates can result in higher revenue and profit growth while rising rates can lead to the opposite.

Prime Rate: the rate that each bank sets as the benchmark for the interest rates it charges on loans. For example, Bank of America explains on its website that its prime rate is based on “the bank's costs and desired return, general economic conditions, and other factors….”  One of these “other” factors is competition, as most large banks tend to have the same prime rate and adjust it at roughly the same time. The “U.S. prime rate,” which is published daily in the Wall Street Journal, is essentially the base rate on corporate loans, calculated by taking the average of the Prime rates posted by at least 7 of the 10 largest banks in the U.S.

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The current U.S. prime rate is 8.5%.This rate tends to move in tandem with the Fed Funds rate. If you can “borrow at prime” from your bank, then you are probably one of their most creditworthy customers.  Loans for customers that are not among a bank’s most creditworthy will be at prime plus a “marginal cost” that depends on the borrower’s credit score, or another measure of the perceived loan risk, and ranges from 25 “basis points” or “bps” (i.e.,  ¼ of 1% or .0025) to 1000 bps (10%) or more.

The 10 Year Yield: the rate or yield that is paid to buyers or holders of the U.S. government’s 10-year treasury note. This yield is the most commonly used U.S. Treasury benchmark interest rate.  It is the reference rate used for the corporate bond market, as well as the real estate market (think home mortgages, mortgage-backed securities, or commercial property loans).  

Not surprisingly, most companies that issue bonds or debt to raise money have to pay a higher rate than the U.S. Treasury. The difference or premium between what the government and companies pay to those who buy their respective debt is called the “spread.”  

High-quality issuers (large companies with sound finances that are virtually certain to repay their bonds/debt) will pay a smaller “spread over Treasuries” to borrow whereas less creditworthy issuers (smaller companies with shorter operating history and/or less stable finances) might pay a spread of 500 bps (5%) or more.

CTA button 2:  Click here for “The Yield Curve,” a brief discussion about yields on U.S Treasuries and other securities.

Money Market Rates: you may have seen our references to “money market” funds or rates in our resources and materials on savings. While some consumers may not be familiar with the term, the money market describes the very short (typically less than one year) end of the fixed income or debt investment spectrum versus the 10-Year U.S. Treasury described above. The 10 year yield is the rate paid by the government for its 10-year U.S. treasuries notes (i.e., medium-term debt that “matures” or is paid back in 10 years). 

Money market funds typically pay better rates than standard bank accounts because they are driven more directly by the Fed Funds rate and the short-end of the U.S.Treasury yield curve.  Typically, a brokerage or investment account on platforms like Schwab, Fidelity, Vanguard, or Robinhood will have the ability to “sweep” or move any cash from your transactions into a money market fund.  Money market funds typically have daily liquidity, meaning that you can deposit or withdraw  money on a daily basis.

Bank Account Rates: Standard bank (i.e., checking and savings) account interest rates tend to be lower compared to the rates offered by other fixed income products  (e.g. U.S. treasuries, money market funds, or even bank certificates of deposits (CDs)), and always lower than the   Prime Rate. It is actually the spread or difference between deposit and lending rates ( the “net interest margin”) that accounts for a good chunk of bank revenues.  

Credit Cards (aka Revolving Credit) Rates: Finally, there is the lovely number that some of us would like to ignore from the fine print in our credit card agreements: it is generally at least 15% and often much higher (historical high of 22.8% in 2023). Credit card rates tend to be relatively high so it’s a good rule of thumb for credit cards to always be a temporary and/or last option for borrowing money.  Banks make it overly convenient for individuals to borrow money with credit cards, and their ideal customer is someone who pays the minimum or more of their monthly bill, yet persistently has a large outstanding balance on which the bank can charge this high rate.  

The best and easiest way to manage this particular interest rate is to never pay it.  It’s a simple function of pluses and minuses –  pay your entire balance prior to the due date every month. If you aren’t able to pay the total balance, it might be time to take a closer look at your expenses and spending habits. Additionally, missed payments and the total amount you owe/have borrowed from credit cards can affect approximately 60% of your credit score.   

Summary

So why should you care about these different interest rates?  If you ever need to get a mortgage or a car loan, the rate has an enormous impact on the total amount that you end up paying.  Similarly, if you have a recurring balance on a credit card, you will feel its impact viscerally each time that you open your statement and see the mounting “finance charges.”

For anyone who is working on their financial health, what interest rates are doing should matter and be taken into account for a variety of important decisions:

1. The kind of mortgage you get. If you think rates are more likely to fall than rise in the future, you might want a shorter-term rate like a 5-1 ARM (which is a fixed rate for 5 years and then becomes adjustable after that, changing with a short term rate benchmark like the 1 month T-bill).  If you think the opposite, you should try for a 30 year fixed rate loan. Folks who locked in 30 year mortgage rates of 5% when Fed Funds were zero and the 10 year UST was below 3% are pretty happy now!

2. Where you put your cash. It is fine to leave enough money in your checking account to operate your life, but you might look at High yield savings, CDs or money market funds to get a better return on your cash.

3. What are you paying on your debt?  If it is high cost revolving credit, work to pay it off.  But if you have a lower rate mortgage or low rate student loans, you might be able to earn a higher return by investing excess cash rather than paying down that debt.

4. Where you invest.  Fed Funds going from 0% to 5.25% should, at a minimum, get you thinking about and researching fixed income investment alternatives.

To sum it all up, interest rates are important because they dictate how much we are paid when we put our savings in money market funds of other fixed income investments, and how much we pay when we want to finance projects or purchases such as homes, cars or education.