Interest rates are like air in that you don’t physically see them but they have a great impact on your life. While air is essential to your survival, understanding what interest rates are and how they work can also help with your overall well-being.
The first step is knowing the definition of interest rates. Essentially, they are a tax on your borrowed money over a given time period and can be fixed or variable. The Federal Reserve is the central bank of the United States, and it sets the fed funds rate as the benchmark. This baseline rate is the starting point for lending institutions which then add on to that with additional fees, etc., to determine a final interest rate on which you are borrowing against.
Whether it is a personal loan such as a mortgage or car purchase, a business loan, student loan or a credit card balance, there is always a fee associated with borrowing money. The higher the interest rate, the more of a premium you will pay above and beyond the amount of money you borrowed.
Interest rates can also be applied in a positive manner. If you have a savings account, the bank will pay you interest on your balance. The longer the money is in the bank, the more interest you accrue. Unfortunately, we have been in a low interest-rate environment for a long time, so the rate of return on bank savings is next to nothing.
As it relates to debt, understanding how interest rates work and how you can manipulate them in your favor is vital to your financial health. It’s human nature to avoid paying attention to our debt to spare ourselves of emotional pain, especially if it is large and feels overwhelming. However, you should regularly monitor the interest rates on your debt.
Watch for drops in mortgage rates, as if they fall far enough, you may want to refinance your loan. If the difference in rates is large enough, you may even want to reduce the number of years in your loan, which could quickly save you tens of thousands of dollars by reducing the overall number of payments you have remaining. The 30-year interest rate is announced every Thursday.
The same goes with credit card debt. If you have good credit and receive offers for low interest rate cards or even zero-percent promotions, then transfer your balance(s) to the card that is more interest friendly.
Low interest rates may also provide an opportunity to tap into equity in your home through a home equity line of credit (HELOC). With a HELOC you could pay off other debt, renovate your home, address an unexpected car or medical expense, or do nothing and let it sit as an emergency fund. Just remember you will pay interest on any money you draw from the line of credit and your payments will be predicated on the interest rate at that time as these loans are typically adjustable.