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Interest rates play a crucial role in shaping the financial landscape, influencing everything from mortgage payments to credit card debt. Understanding how these rates work can empower you. Knowing their implications helps you make informed financial decisions that positively impact your wallet.
This guide will help explain some of the key terms. It aims to better understand interest rates and their impacts on the general economy. It also discusses effects on the consumer.
What is Interest Rate ?
At its core, an interest rate is the cost of borrowing money, expressed as a percentage of the principal amount.
Central banks generally fix the interest rate. Examples include the Bank of England, the European Central Bank, and the Federal Reserve in the US. They make decisions depending on the current state of the economy. Usually interest rate can be decreased when there is an Inflation.
Once the decision is made by central banks to fluctuate the interest rate, the commercial banks (e.g.,HSBC, Bank of America …) will align, and adjust the interest rate on their products (personal and business Loans, mortgages, credit cards, Savings, ISA, etc.). We can therefore say that the change in interest rate affects the general economy. It also affects personal and business borrowing products.
How to Identify the change of interest rate on your personal financial products ?
As an individual or a business, the economy’s interest change will affect your APR and APY. It will impact your loan, mortgage, and savings too.
The APR determines how much money you pay in fees. When you’re trying to decide which type of loan to take out – mortgage, car loan, or personal loan.
Similarly, when looking for a saving account, a current account, or an ISA, consider the interest rate. It will help you decide which one is best.
Note that an increase of interest rate may be good for savings account but not necessarily for borrowing products.
Deciphering Financial Language: Defining APR, APY, and Effective Rate
Annual percentage rate (APR) – The interest rate you would receive if you were to take out a loan. The annual percentage rate is the amount of interest you would pay per year on a loan.
Key notes
- APR or Simple Interest Rate is calculated as follow: Principal amount x interest rate x time.
- Annual percentage yield (APY) can also be called Compound Interest Rate
- Effective interest rate – The effective interest rate is the interest rate you actually pay after all terms are factored in
Annual percentage yield (APY) – The amount of interest you would earn if you deposited money in a savings account. The annual percentage yield is the amount of interest you would earn on a savings account.
The Annual Percentage Yield can also be called Compound Interest Rate mostly advertised by Investment banks. However, some lenders are now practicing this interest calculation on loans or credit cards.
Compound Interest is also called interest on interest, it is advantageous on savings account, but will lead the borrower to pay even more on interest.
Effective interest rate – The annual percentage rate minus the terms of the deal. The effective interest rate is the interest rate you actually pay after all terms are factored in. If you see an interest rate advertised, you might see two numbers: an annual percentage rate (APR) and an annual percentage yield (APY). These are two ways of expressing the same interest rate. It’s important to understand what these numbers mean and how they’re calculated
Why Are Interest Rates Increasing?
Interest rates have a direct correlation with the economy. When the economy is doing well, interest rates tend to go up. When the economy is doing poorly, interest rates go down. There are two major factors that affect interest rates: inflation and monetary policies. Inflation happens when the demand for goods and services exceeds their supply in the economy.
When this happens, the value of the currency declines. Most central banks use interest rates to control inflation:
When inflation is high, they raise interest rates; when inflation is low, they lower the interest rates.
Higher interest rates encourage people to save their money by making it less desirable to take out loans.
Central banks and The Federal Reserve (US) have two main purposes. Their first purpose is to stabilise interest rates and prevent inflation. Their second purpose is to manage the monetary base, or the amount of money in circulation. This ensures that its members can keep up with economic growth.
How Will Higher Interest Rates Affect You?
When interest rates are low, it’s more appealing to take out loans and invest in risky assets.
When interest rates go up, it becomes more expensive to borrow money. Buying a house, car, or starting a new business costs more. It also becomes less appealing to take out risky loans since the interest rates are higher.
The US Federal Reserve raised interest rates in March 2017. When the Federal Reserve raises interest rates, it increases the cost of borrowing money. This can lead to higher debt levels, which can then be difficult to refinance or sell.
When it comes to buying homes, a mortgage is a risky loan. It can lead to higher debt levels if the borrower doesn’t pay on time. The borrower may also face issues if they fail to make good on their payments. If the home is worth less than $300,000, refinancing a house loan will cost over $1 million.
How Can You Protect Yourself?
If you’re in the market for a home, you need an honest and trustworthy attorney. They will help you understand your rights. They will also help you protect yourself from predatory lending practices. If you have any questions about your rights, contact an attorney who specializes in residential property law. They will inform you about the laws in your state or country.
Strategies to Survive Rising Interest Rates
You now understand how interest rates work. You know how they connect to the economy. It’s important to make sure you are prepared. Be ready in case interest rates rise even more.
Stay Current on Your Debt. If you have credit card debt, student loans, or a mortgage, pay it off as quickly as possible. The less debt you have, the less you have to worry about paying interest rates.
Start Saving. You should have more money saved in your emergency fund. This way, you must worry less about rising interest rates. Additionally, having more money in your retirement account also reduces your concern about interest rate increases.
As interest rates rise, it’s wise to review all your financial accounts. This will guarantee you’re still getting the best interest rates possible. – Keep an Eye on Your Savings – Make sure that you’re cautious with your spending. This is essential when it comes to saving.
If you’re spending too much, you’ll be in a better position to pay off your debt when interest rates rise.
How To Get Out Of Debt?
You might think that getting out of debt would be easy and simple. It requires more than just asking for help. You have to take action and make the decision yourself. You have the ability to do this. You have access to financial resources. You can choose how you want your life to change from now on.
If you do not ever plan on being in debt, start taking steps now.
Further Readings
