by Maja Majewski

Why do interest rates change?

Ever wondered: Why do interest rates change? Here’s a primer on the many factors that affect interest rates, to help you make smarter money decisions.
Why do interest rates change?

When it comes to personal finance, interest rates can be confusing. For one, depending on if you’re paying or earning interest, a ‘high interest rate’ can either be anxiety-inducing or a great financial tool.

If you’ve ever been in the market for a savings account, credit card, student loan, car, or mortgage, you probably know something else about interest rates: Interest rates are always in flux. For example, the federal funds rate—the rate at which banks lend to other banks and the basis for most consumer interest rates in the United States—has moved about quite a bit, from 0.25% to 19% since 1954.

These changing rates matter to you because the fed funds rate determines most consumer interest rates on products you’ll likely use at one point or another: - Banks’ prime rate (the rate banks charge customers for loans)–like student loans, personal loans, and certificates of deposit (CDs) - Adjustable-rate mortgages - Credit cards

Why do interest rates change?

What causes rates to vary so much? There are many reasons, but two key factors are the supply of money and inflation. Here’s a brief primer on why interest rates change, why you should care, and what you need to know before making any financial decision involving paying or earning interest.

The Fed

The US central bank—better known as “the Fed”—has two primary goals: full employment and stable prices. The Fed seeks to achieve these goals by creating monetary policies that can increase or decrease the money supply. It uses interest rates as a lever to stimulate or slow the economy.

If the economy is slowing, the Fed can lower interest rates to make it cheaper for businesses to borrow and invest money and create jobs. Lower interest rates also tend to encourage consumers to borrow and spend money, helping to spur economic growth. When the fed funds rate goes down, mortgage rates and the rates on short and long term loans go down too.

The Fed primarily controls the supply of money by buying or selling government bonds through a process known as open market operations.

Banks hold reserves at the Fed, and through open market operations the Fed enters into transactions with banks to buy or sell government bonds. When the Fed buys securities from a bank, the Fed increases the amount of money in the bank’s reserve account at the Fed. With a greater supply of money on hand, the bank has an incentive to reduce the rate of interest it charges borrowers.

Supply and demand

The interplay between borrowers’ demand for money and lenders’ supply of money also has an impact on interest rates. At the micro level, if a bank experiences greater demand for its loans relative to its supply of deposits, then its interest rates tend to rise. In order to lend additional money, the bank must incur additional costs—either from borrowing money from another bank, raising capital, or increasing the rate it must pay depositors to attract additional deposits.

Ultimately, the bank passes these costs on to borrowers in the form of higher interest rates.

Inflation

Interest rates also can vary because of inflation. When determining the interest rate to charge borrowers, lenders factor in their estimates of what future price levels will be in order to ensure lenders will profit from the loan. High inflation, or anticipated inflation, will result in higher interest rates.

For example, in the 1970s, the United States experienced greater levels of inflation after the Federal Reserve “loosened” the money supply. The Fed’s intention was to reduce unemployment, but it not only failed to keep unemployment in check, but also resulted in inflation that averaged almost 10 percent from 1974 to 1981 (2-5% is considered ‘healthy’).

In response, the Federal Reserve “tightened” the money supply, taking money out of circulation by selling government bonds. As a result, the federal funds rate skyrocketed from five percent in 1976 to over 13 percent in 1980, in large part because there was significantly less money to loan out than was being demanded by consumers and businesses.

From the early 1980s through today, interest rates have fluctuated significantly. After the hyperinflation of the 1970s, interest rates remained high during the early 1980s, peaking in 1981 at over 16 percent. During the mid 1980s and early 1990s, the federal funds rate declined, ranging from 5 to 8 percent. Spurred by the economic boom of the 1990s, interest rates hovered between 3 and 6 percent, hitting the top end of the range as the dot-com and housing bubbles burst during the early 21st century. You can check the current fed funds rate here.

The Federal Reserve has kept the federal funds rate low in recent years in an attempt to stimulate economic growth. At Simple, we aim to always be transparent about changing interest rates, and work hard to keep interest rates on our financial products competitive.

You can learn more about how interest rate changes affect you in this post.

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