2 Min Read
Whether you're a budding investor or a seasoned pro, it's natural to want to park your idle cash where it will generate the most lucrative return. Maximizing your savings can help you attain various financial goals, everything from purchasing a rugged SUV for adventurous road trips to funding a lavish retirement on a secluded, tranquil island in the South Pacific.
Conversely, suppose you're scouring the lending market for a mortgage, line of credit, or personal loan. In that case, you instinctively gravitate toward the lowest interest rate.
Understanding how interest rates affect both savings and loans is prudent, as the two are inextricably linked. But how, exactly, does this relationship work in the real world?
What Are Interest Rates?
An interest rate refers to the cost of borrowing money. And like any good or service, this cost fluctuates based on the laws of supply and demand.
As the money supply increases, it becomes easier to secure, so the interest rate drops. The opposite occurs if the money supply shrinks - it becomes scarce and, thus, more costly to obtain. Likewise, when demand for money rises, so does the interest rate, and vice versa.
Interest Rates for Savings
Banks and similar financial institutions offer interest payments to entice customers into providing them with cash for safekeeping, which, in turn, enables them to issue loans.
The quickest and most convenient way to start earning interest on your money is to open a bank account with a savings account. Another option is a certificate of deposit (CD), which is a safe and reliable investment product that pays a higher interest rate than a typical savings account. The one condition of a CD is that your money is locked away for a set period of time.
A checking account may generate some interest income, but it's trivial, as its purpose is to cover your daily spending needs.
Interest Rates for Loans
Just as you can earn interest income from deposing your money at a bank, you'll be responsible for paying interest charges when you take out a loan.
Banks assign your loan interest rate on two factors: the loan type and default risk associated with lending to you.
For example, rates on mortgage are considerably lower compared to an unsecured personal loan, as the former is supported by your home (which the lender can liquidate in case you fail to make your payments), and the latter is backed only by your general creditworthiness.
Lenders will evaluate your credit report and income when it comes to risk. If they deem you capable of servicing your debt payments, they'll reward you with a low-interest rate.
How Are Interest Rates on Savings and Loans Linked?
The interest rates on savings and loans are heavily influenced by the Federal Reserve, whose primary duty is managing the monetary policy of the United States. It accomplishes this mainly by adjusting the federal funds rate, which is the rate commercial banks charge each other when lending and borrowing. In general, it raises rates to prevent the economy from overheating and cuts rates to stimulate economic activity.
Should the Fed raise the federal funds rate, it will cause a ripple effect that trickles down to your local bank. Borrowing costs for lending institutions will increase, and to offset this, they'll charge higher rates on loans they originate. In turn, this enables them to hike the interest amount they pay on various investment products, such as savings accounts, CDs, and money market funds. As a result, you'll realize a tidier return on the money you invest, accelerating the pace at which you reach your savings target.
Of course, the opposite is true if the Fed decides to slash rates. The cost of borrowing will fall across the economy, which means you can expect a meager return on your cash deposits.
Why It’s Wise to Pay Attention to Interest Rates
As you can see, high interest rates are disheartening if you're seeking a loan but exceptionally advantageous if you're eager to grow your savings. Of course, the opposite is true in a low-interest-rate environment - finding a place for your money to earn a decent rate of return is more challenging.
While you don't need to keep a watchful eye on the financial markets daily, it's helpful to be aware of which direction interest rates are trending. Once you have a grasp on how to start investing, you can use this knowledge to know when to level up your savings. Making wise investment decisions and adjusting your portfolio is crucial for maximizing your returns, no matter the state of the economy.
And there are easy ways for you to begin investing with apps like Monorail. See what investments with Monorail could look like for you.
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