I’ve taken an interest, to enlighten you about interest rates during this week’s blog post.
At this point, I may have lost some readers now because it’s just…one of those topics. You know, the type where you’re sitting there speaking to someone and all of the sudden they start talking interest rates and only Charlie Brown’s teacher speaking starts playing in your mind. Next thing you know your eyes are just as glazed as those doughnuts that your co-worker brought to the office last Friday. The unsettling thing is that regardless of if we know what interest rates are or not, they are consistently surrounding us in everyday life. We have interest rates on school loans, car loans, mortgages, credit cards, savings accounts…etc. But do you really know what interest rates are?
Let’s take a visit back to your past economics or math classes (yes, I too am more of a so called ‘right brained’ individual – but bear with me!). We are going to make going through this post as painless as possible, because it is important for me to build up your personal finance vocabulary as much as I possibly can. This post is going to break interest rates into 3 parts/questions (and that’s it!): 1. The definition of interest rates (with a simple example) 2. How are interest rates determined? 3. What is the importance of interest rates to Millennials?
I guarantee you will be able to finish reading this post faster than you listen to an entire song on Spotify. So let’s kick this thing off, shall we…
1. What is the definition of interest rate?
“The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets” (investopedia.com).
As an example (for simplicity & clarity, my example covers simple interest):
Borrower – Daisy
Lender – Gatsby
Principal of loan – $5,000
Interest – $250
Daisy (the borrower) is charged an annual interest rate of 5% (of the principal/total amount being borrowed – $5,000) by Gatsby (the lender) for the use of his money to buy a yacht she currently does not have the funds for. Since Gatsby is lending Daisy money, and it is a risk that she could potentially not pay back the total $5,000 in a year, there is interest (cost for borrowing the money) involved. The interest acts as extra coverage for the lender (Gatsby). The cost (interest) for borrowing Gatsby’s money is $250, for a total of $5,250 that Daisy will actually pay.
5% of the amount borrowed – $5,000 x .05 = $250
Amount originally borrowed plus interest (cost of borrowing Gatsby’s money) – $5,000 + $250 = $5,250
Essentially, borrowing money you do not have will cost you interest. Lenders are taking chances on people by loaning people money.
2. How are interest rates determined?
There are several intricacies that go into the why and how of the way interest rates are determined. The main driving force behind interest rates is the Federal Reserve. To keep the nation’s economic status in equilibrium, the Federal Reserve will lower or raise interest rates (whether it be short term, or long term). As simple indicators, if the economy is strong and on the rise fast, interest rates will typically be higher to avoid inflation (I could imagine at some point in your life you’ve heard the coined phrase, ‘too many dollars chasing too few goods’). If the economy has reached a slow down phase, interest rates will be lowered in order to allow more people incentive to borrow money (‘Investing Basics – How interest rates are determined’ at bankrate.com). As we may have encountered before, interest rates can change daily, monthly, or yearly.
3. What is the importance of interest rates?
At some point in your life, you will come across interest and interest rates. As we are leaving school, developing in our careers and purchasing more big ticket items than in our youth, interest rates come front and center. The value of our dollars saved & spent is pivotal to our growth, so understanding the where & how your money is spent will give you a sense of empowerment. From student loans, to car loans, to credit card payments and everything in between – we have a responsibility to pay for these purchases/investments that we could not afford at that given moment in time. Luckily, if we do research, comparisons and make responsible payments, interest cannot get the best of us. Prove to that lender that you are the responsible Generation Y/Millennial that I know you are!
There we have it, a simple & concise lesson on interest rates. For some of you, this may have been a refresher. For others, maybe it was the first time you really thought about it. Whichever category you fall into, I commend you for expanding your knowledge on personal finance! Before you leave, check out this easy to follow video via Wall Street Survivor for a 2 minute video on interest rates –
Increasing your personal finance knowledge one post at a time…
All my best,