How Interest Rates Are Determined?

Interests rates are very important to consumers who are in the market for a home, auto loan, or who are setting up a long-term investing account. Unfortunately, the average user is at a huge disadvantage because the calculations of interest rates are a bit cloudy and difficult, unless you have taken a few years of business school. I will attempt to break it down to bite size morsels of information to help mental digestion.

Interest rates fluctuate as a mirror of a number of factors, namely, the Federal Reserve. The Federal Reserve is in charge of maintaining the stability of the nation's financial system, in turn, it raises or lowers the short-term interest rates. The "Fed" takes actions daily in a response to the economic difficulties the economy goes through on a daily basis.

When the economy is in expansion, the short-term rates are often raised to lessen the risk of inflation; inflation is the surplus of money circulating. When there is inflation the value of the dollar plummets, sending prices upwards to compensate. Thus, raising interest rates gives the economy room to breathe and slow down. This gives business and consumers less of a chance to borrow money, which in turn, means less money in circulation.

Lower interest rates happen when the economy is going down, or the stock market is in a huge bear downturn. The Fed will lower short-term rates when the economy is slowing down. This allows big business and consumers the ability to borrow more money to allow the circulation of additional security. Therefore, if you are in the market for a home, a slow economy may be a good thing in the end.

Other factors come into play when we are talking about interest rates: crisis, foreign prices, natural disasters, etc. A quick rule of thumb is when rates are high, you are earning more on your chunk of savings money; when rates are low, it is much cheaper to borrow money.