Make sense of interest rates
Interest rates are the cost of borrowing money or the return you get for lending money. You may feel like an expert in borrowing if you’ve ever had a car loan or used a credit card. What you may not realize is you are a lender as well. When you open a bank savings account, you are lending money to the bank. Owning shares of stock gives you a claim on a portion of a company’s assets and earnings. And, if you invest in the bond market, it’s like you are lending money to the corporation or government entity issuing the bond. Either way, interest rates impact you.
Meet the Fed's funds rate
When interest rates make the news, it’s usually because of the federal funds rate. This is set by the Federal Reserve Board or “the Fed,” and is used to control the supply of available money. Banks use the rate to determine how much to keep on hand, what to charge for foreign exchange rates and to set government bond prices. Why does this matter to you? Because it affects how much you pay for things like home mortgages, small business loans and credit card debt. It also moves the expected savings rate on bank accounts, Certificates of Deposit and other types of bonds. It can even impact the stock market.
Interest rates may rise and fall on their own with inflation or deflation. The Fed monitors this movement closely and adjusts rates to keep them from getting out of control. Paying attention to the federal funds rate may help you decide when to take out a loan, refinance a mortgage or find a new savings account.
Get to know rates of return
The rate of return is how much you earn or lose on an investment each year. It’s expressed as a percentage of your initial investment. If your rate of return is 10%, that means you would have 10% more than you did when you put your money in. Rates of return can include investment gains as well as dividends, which are additional profit-sharing payments some corporations make to their stockholders.
Between 1926 and 2018, the stock market, as measured by the Standard & Poor’s 500 Composite Index, has returned an average annual rate of around 10%1. But don’t expect that every year. Past returns are no guarantee of future results, and returns may be higher in some years and lower in others.
Make sense of bond yields
Rates of return for bonds are called yields, and they have averaged more than 7% each year for U.S. Government bonds2. But how you get to this number can be a bit complicated. The interest paid by a bond is known as a coupon; it’s a regular fixed rate you receive as long as you hold the bond. The original cost of the bond is called its face value. Together, the coupon and face value determine the bond’s yield each year. For example, if you have a bond with a face value of $1,000 and an annual coupon rate of 3%, the bond will pay you a yield of $30 per year.
The tricky part is that bonds can change in price, above or below the face value, which changes the yield an investor can expect. Bond prices can be complex. For this reason many investors opt for bond mutual funds, which offer exposure to bonds and provide a measure of diversification.
Pay debt interest or earn investment interest?
For many of us, making sense of interest rates comes down to one question: Is it better to invest your money or use it to pay off debt? The answer is somewhere between “it depends” and “do both.” Here’s why.
Americans owe trillions of dollars in credit card and other debt, according to the latest data3. At a time when savings rates are low, credit card interest rates can be astronomical, charging consumers anywhere from 14% to 25%. If you carry debt, paying it down may be an important goal.
Another priority may be saving for retirement. One benefit to saving in an employer-sponsored 401(k) or an individual retirement account is that your rate of return can grow without being taxed until retirement. This helps your interest accumulate more quickly, which is known as compounding. It may not seem crucial today, but think of saving for retirement as a form of self-care that can pay off when you may need it most.
Consider dividing priorities
If you aim to put away a portion of your income toward debt and savings — say 15% to 20% — you can find a way to do both. When your employer offers a 401(k) match, save as much as you need to take full advantage of it. It’s free money, after all. Consider putting whatever is left over toward debt, paying off loans with the highest interest rates first.
A bit of knowledge about interest rates may help you make better debt choices in the future, allowing you to shift a greater portion of your income toward savings over time.
1Average annualized return of the Standard & Poor’s 500 Composite Index from 12/31/1927 to 7/31/2020 was 9.88% not including dividends. Past returns provide no guarantee of future results.
2Average annualized return of Bloomberg Barclays U.S. Aggregate Index from 12/31/1975 to 7/31/2020 was 7.39%. Past returns provide no guarantee of future results.
3Outstanding consumer credit totaled $4.08 trillion as of June 30, 2020, according to the Federal Reserve.