We are all familiar with interest that we pay on either a car, home, or credit card payment, but what exactly is interest and how does it work? Interest is payment from a borrower to a lender of an amount above repayment of the amount borrowed at a particular agreed upon rate. There are some shady loans that have a floating interest rate, which basically means the rate isn’t set in stone and if interest rates rise so will your loan. Basically a lender is charging you a fee to use/borrow their money. The Federal Reserve also known as the Central Banking System sets monetary policy by influencing the federal funds rate, this is the interest rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. All major banks have to keep around 6% of assets in an account held by the Federal Reserve and they can loan to each other out of that pool of funds. Banks have to keep a certain amount of money on hand to cover the loans they have outstanding as part of the FDIC guarantee, so banks that have excess capital can loan it to banks that are short on liquid funds, so loans made from bank to bank are from the federal funds and the terms of the loans are agreed upon between the two banking institutions and then all the loans interest rates are averaged out and that is how they get the Federal Funds Rate, or the interest rate that banks are charging each other to borrow money. Based off that rate the banks then make loans to public and private people or institutions at higher interest rates than they are being charged. If you have a great credit score then you can get what is called the prime interest rate, prime rate is what’s considered the best rate on the market, however the lower your credit score the higher the interest rate because they view the loan as being riskier. So now that we know how interest rates are determined, how do they affect us?
The term annual percentage rate of charge (APR) the interest rate for a whole year (annualized), rather than just a monthly rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual rate, Basically it is the yearly interest rate multiplied by the number of payments to be made in a years time, most are 12 monthly payments. There are two main types of interest
Compound interest is the addition of interest to the principal of a loan or deposit, or in other words, it’s interest being charged on interest. This interest can be compounded yearly, quarterly, monthly, or even weekly in some cases. Basically the interest isn’t paid in full each month and the next months payment is interest charged on the unpaid interest from the prior month.
Simple Interest is interest computed only on the principal and (unlike compound interest) not on principal plus interest earned in the previous period. This type of interest is most commonly used by lenders making short term loans such as for cars, When you make a payment the interest being charged is payed first and then the rest of the payment is applied to the principle loan amount, therefore the interest is paid in full every month and doesn’t add to the next month’s payment.
If you pay someone else interest, by the time you finish paying off the loan you will have paid much more than the original amount/value of the item you financed. This is why it is so important to stay out of debt. Interest is very powerful, in fact Albert Einstein said it was so powerful that it should be considered one of the great wonders of the world. This is why you want to invest in items that earn interest for you like stocks or bonds. Now I will say that there can be good and bad debt. Bad debt would be taking out a loan for a car that is worth less as soon as you drive off the lot and cost you money to keep it running, you are paying interest on something that is constantly losing value and takes money to keep it going. On the other hand purchasing a home as a rental property could be considered a form of good debt, as long as you purchase the home for less than the actual value, (below market value) lock in a low interest rate, have enough money to cover any repairs and vacancies, and are able to rent it for more than the monthly mortgage payment. In this scenario you are taking a loan on something that gives you immediate equity, (value) should continue to rise in value, and provides income, all while someone else is paying off your loan. This is in my opinion good debt and is a way to use interest rates to your advantage. When interest rates are low it is a good time to make large purchases and lock in the low interest rates. However low interest rate environments tend to drive up the cost of consumer items such as homes because more people are in the market to buy due to loans being easier to acquire.
Another way interest rates affect us as investors are through our retirement accounts. Interest rates cause the price of stocks and bonds to rise and fall, actually just the mere talk of a change in interest rates can cause stocks and bond prices to move up or down in anticipation. When interest rates go up it lowers the price of bonds issued at the lower interest rates. Bonds are guarantees from corporate or government institutions, they are basically a promise to repay the loan at a set date plus yearly interest payments for the right to use your money. So they money you receive monthly and the amount they guaranteed to repay won’t change but since bonds can be traded on the secondary market they are seen as less valuable because now that rates have gone up why would an investor buy your bond from ABC company at a 3% interest rate when they can loan money and get 5% interest now? With stocks it’s a little different. since stocks are small pieces of public companies they react differently to interest rates. It’s hard to make a broad statement because there are so many different companies form banks, to REITS, to retailers, and everything in between and all will be effected differently by a change in interest rates. In general though a drop in interest rates increases consumer spending and makes borrowing money to expand cheaper, so that usually helps most businesses. However low interest rates can and have caused inflation and that can wear away savings, especially of retired individuals living off of savings. Rising interest rates can hurt companies that require large amounts of loans such as real estate, builders, or manufacturers. This also can cause people to make fewer purchases of large items, which has a trickle down effect on many other sectors. This can cause deflation which makes things cheaper but also devalues assets as well. As we learned earlier the Federal Reserve can change interest rates and will do so to try to stimulate an economy or cool off an overheated economy.
The take away from this should be two fold. One now that you know what interest rates are and how they effect you, keep and eye on the Federal Rate and understand how it’s movement could affect your investments. Secondly know how to use interest to your advantage by locking in low rates on large purchases for “good debt” items, and buying bonds with high yield rates while interest rates are high and companies are willing to pay more to borrow your money. I hope this article was helpful, thank you for taking the time to read it.
Chef On FIRE……..