There has been a lot of media coverage lately about “interest rates.” When you see this mentioned, usually what they’re talking about is the federal funds rate. In simple terms, this is the standard rate that banks charge each other to borrow loans. While that might not seem to have any impact to you as an individual, it does because much of our financial economics are tied to what that fund rate is.
While it is not necessary for you to obsess over what the rates are – believe me, plenty of other people are doing that – you should have a basic understanding of how interest rates affect your wealth-building activities. Here’s a quick overview.
The ‘base’ figure on our wealth calculator is a savings rate, so it’s worth mentioning the connection between savings rates and the federal funds rate. Banks actually base their savings rate on the fed interest rate – so, if the fed interest rate is high, the savings rate goes up as well. If you think about it, this makes sense; a bank wants your cash, so they keep their savings rates in line with the fed rate so it is competitive.
The rates that banks charge for lending also trends up and down with the fed rate. This is most often felt with mortgage rates and the infamous adjustable rate mortgage (ARM), which goes up and down in alignment with the fed rate. But, there are also adjustable rate credit cards that do the same, and overall lending rates do lift and lower somewhat in relationship to the fed rate. This is good to know if you are thinking about getting into real estate as part of your wealth portfolio. And regardless of what rates are doing, you should be paying off high-interest consumer debt (like credit cards).
Last but certainly not least, is stocks. The way in which federal interest rates affect the stock markets is somewhat convoluted – a bit of a butterfly effect. Here are the two main ways in which stock prices can be affected:
- Market Confidence: The fed changes their interest rate to help encourage a sluggish economy to keep moving, and to slow down an overheating economy. Thus, investors use any decisions the fed make as an indicator about what they think the overall economy is doing. A good economy with future potential = rising prices, investor confidence. An economy that might be faltering = dropping prices, low investor confidence. Keep in mind that this is about confidence, it doesn’t necessarily mean the sky is falling, so be sure to do your homework before making any rash decisions in the face of market changes.
- Cost of Capital: Just like you, as an individual, can be affected by a rising or lowering rate, companies are the same. Companies that require a lot of access to lending and capital can find their costs of getting capital in the door go up, which can mean the companies overall valuation can go down.
Figuring out the impact of rates on a specific stock in your portfolio is a bit of an advanced, subjective topic; in general, our view is to look at a company’s overall long term potential, and less about how interest rates affect them. Using automated solutions like Betterment (click the link for our review) is a great way to not have to worry so much about rates.