An interest rate represents the cost of borrowing money. Interest rates are not inherently good or bad; in fact, your perception of what makes a good or bad interest rate likely will depend on which side of a transaction you're on. But interest rates carry great importance beyond personal finance issues. Interest rates affect everything from government financing costs to economic output and stock prices.
Purpose of Interest Rates
If you ever borrow money, you'll pay an interest rate to the lender. Interest rates are a way for lenders to make a profit. They also compensate lenders for the loss of the use of the funds. For example, say a bank lends you $10,000. While that money is lent out, the bank cannot use it to make other loans or investments. The only income for the bank is the interest rate it charges you.
Without interest rates, lenders wouldn't extend their capital to borrowers. Without capital, economic expansion would dry up. Companies need capital to expand, and individuals need capital to buy things such as homes and cars. Interest rates keep the business of lending running.
Interest Rates and Investments
If you're an investor who likes to generate income out of your investments, interest rates – especially high interest rates – are a good thing. If you buy a Treasury bill, for example, you're actually lending the government money. In exchange for the money you lend, the government pays you an interest rate. The same is true if you buy a corporate bond, except in that case you're lending your money to a corporation rather than the government. The higher an interest rate you can get, the more income you'll generate.
Interest Rates and Personal Finance
The downside of interest rates comes if you're a general consumer. Any time you have to borrow money, you'll pay interest out of your pocket. This increases the cost of your original loan.
Consumers borrow money in numerous ways. The danger is that some of these loans might not feel like borrowing at all. For example, when you charge purchases on a credit card, you're taking out a loan unless you pay your balance in full every month. If you take out a home mortgage or an auto loan, you're borrowing money. Each of these transactions has an interest rate attached. The longer you take to pay off your loans, the more you'll end up paying.
Interest Rates and the Stock Market
To some degree, rising interest rates can be a plus for the stock market as they reflect a growing economy. And in a growing economy, companies have the ability to raise prices, thereby generating more profit. However, if rates get too high, economic growth is stifled. Most companies borrow money to finance their expansion, so if interest rates rise, so too do their costs. When corporate profits shrink, otherwise known as an economic recession, stock prices fall.
Interest Rates and the Fed
When the economy expands rapidly, there's a risk of it overheating. Too much growth too quickly can spur inflation, which raises the costs of goods and services throughout the economy. To combat inflation, the Federal Reserve Board will raise interest rates. Rising rates restrict corporate growth, thereby slowing the economy and bringing inflation back in line. While rising rates might hurt consumers over the short run in terms of rising credit card and loan expenses, in the long run, consumers are better off with lower inflation.