WHAT IS THE INTEREST RATE

Generally, supply disruptions coupled with strong demand for goods, rising wages and higher commodities prices challenge the global economies and farther push inflation above central bank targets. To contain price pressures, many central banks have to tightening monetary policy, leading to a sharp increase in nominal interest rates.

An interest rate measures both how high the cost of borrowing and high the rewards are for saving. For instance, if you’re a borrower, the interest rate is the amount you are charged for borrowing money, shown as a percentage of the total amount of the loan. The higher the percentage, the more you have to repay a loan.

However, if you’re a saver, the savings rate tells you how much money will be paid into your account, as a percentage of your savings. The higher the savings rate, the more will be paid into your account.

Why Understanding The Interest Rate is Important

If interest rates rise, borrowing money could become more expensive. For households who are looking to get a mortgage, or a new car on credit, the high interest rate costs mean that if you have a 130,000 USD mortgage that you want to pay off over 25 years with interest rate on the mortgage of 2.5 percent, the monthly repayment will be 583 USD. However, if the interest rate is 3.5 percent, the monthly repayment will be higher, at 651 USD.

Of course, if the mortgage interest rate was 1.5 percent, the monthly repayment would be less or around 520 USD.

Different Types Of Interest Rates

Simple Interest Rate. If you take out a 300,000 USD loan from the bank and the loan agreement stipulates that the interest rate on the loan is 4 percent simple interest, this means that you will have to pay the bank the original loan amount of 300,000 USD + (4 percent x 300,000 USD) = 300,000 USD + 12,000 USD = 312,000 USD.

Compound Interest Rate. Some lenders prefer the compound interest method, which means that the borrower pays even more in interest. Compound interest is applied both to the principal and also to the accumulated interest made during previous periods. The bank assumes that at the end of the first year the borrower owes the principal plus interest for that year. The bank also assumes that at the end of the second year, the borrower owes the principal plus the interest for the first year plus the interest on interest for the first year.

Compound Interest On Savings Accounts. When you save money using a savings account, compound interest is favorable. The interest earned on these accounts is compounded and is compensation to the account holder for allowing the bank to use the deposited funds.

Annual Percentage Rate APR. The annual percentage rate (APR) is interest rates on consumer loans. This is the rate of return that lenders demand for the ability to borrow their money. For example, the interest rate on credit cards is quoted as an APR. In our example above, 4 percent is the APR for the mortgage or borrower.

Annual Percentage Yield APY . The annual percentage yield (APY) is the interest rate that is earned at a bank or credit union from a savings account or Certificate of Deposit CD. This interest rate takes compounding into account.

What Happens When Interest Rates Rise

Rising interest rates impact your finances in many different ways. Some are positive, while others are negative. Knowing what is likely to happen will give you an opportunity to prepare your finances to deal with the potential increase in rates. Below are the six things that typically happen whenever interest rates rise:

1. The Cost of Borrowing Money Increases. When the interest rates increase, the cost of borrowing money become expensive. Specifically, borrowers with variable interest rate debt are affected immediately as rates increase. However, existing fixed-rate loans are not affected
   1. Lenders Earn More Interest. People who have money in saving accounts, money market accounts and Certificate of Deposits CDs benefit from rising interest rates. Banks increase the rates they pay on saving accounts to attract new customers and retain deposits from existing customers. Savings accounts typically increase within a month of the Federal Reserve increasing rates. However, the Certificate of Deposit CD’s rates are fixed until it matures. New Certificate of Deposit CD rates vary based on market rates.
   2. Consumer Demand Decreases. When it costs more to borrow, consumers tend to reduce how much they spend. Unless their income increases too, the rising interest rates shrink their disposable income.
   3. Stocks Market decreases. When investors can earn higher interest on bank deposits and bonds, stocks become less attractive. In essence, investors don’t have to accept as much risk to generate the same returns on their money. Because of this, some investors sell off some assets and reallocate that money into Certificate of Deposits CDs, bonds and money market accounts.
   4. Bond Values Drop. Higher interest rates lead to the decreased value of existing bonds. When an investor can receive a higher return on a newly issued bond, there is less demand for existing bonds with lower rates. Although the current price is lower, if you hold onto your bond until maturity, you’ll receive the full face value. That is not the case with bond mutual funds and Exchange Traded Funds ETFs. They reprice daily based on the value of the bonds within the portfolio and rarely hold bonds until maturity.
   5. Mortgage Is More Expensive. Household budgets and underwriting limits place a cap on how much homeowners can pay each month for their mortgages. Prospective homebuyers have a harder time qualifying to buy a new house as rates increase. The higher rates increase the monthly payment needed to buy their home.