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Interest rates explained

Interest Rates Explained

Al Waller: This year, interest rates have been a hot topic. To that point, a Google search on the term “interest rates” returned nearly 2.7 billion hits! This is probably due to the buzz about rising interest rates. But just what does this mean for us and what do we need to know?

Welcome back to to ClearPath – Your Roadmap to Health & WealthSM. I’m your host, Al Waller. With us today is Catherine Collinson, CEO and president of nonprofit Transamerica Institute®. Catherine is here to explain interest rates, describe how they work, and help answer other related questions.

Before we get started, I want to encourage our listeners to reach out to us and share what topics you'd like to hear about. You can do this by simply dropping us a line at info at [email protected].

Catherine, nice to be together again.

Catherine Collinson: Hi Al. It’s great to be back.

Al Waller: I feel like most people have a general idea of what interest rates are but may be missing some of the key elements as to why they're important. So, could you start us off by providing the basic fundamentals of what interest rates actually are?

Catherine Collinson: Very simply, interest rates are the rates charged for borrowing money or paid for lending money. Most of us are familiar with borrowing money – be it for a car loan, home loan, or credit card balance. But what fewer people realize is conceptually, many of us are also lenders. When we open an interest-bearing savings account or CD, we're lending money to the bank.

Al Waller: Good point. I don't often think of us considering ourselves as “lenders”, per se. But on the flip side, I know I have a much better sense of what it means to be a borrower, and I can tell you that I've been paying close attention to the Federal Reserve in recent months – as I'm sure others have, with its announcements of rate hikes.

Could you walk us through what role the Feds play in interest rates?

Catherine Collinson: Sure, the Federal Reserve, otherwise known as the Fed, is the central bank of the U.S. Its role is to provide our nation with a safe, flexible, and stable monetary and financial system.

If you're interested in learning more, this role is explained in greater detail on the Fed's website at www.federalreserve.gov.

The Federal Reserve, or the Fed, sets what's called the Federal Funds Rate, which is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. When the Federal Funds Rate changes, other interest rates fluctuate as well, with examples including mortgage rates, car loan rates, and even student loan rates.

Al Waller: As most have noticed, the Fed has increased this rate several times this year, which begs the question – why are they doing this now and so often, for that matter?

Catherine Collinson: Well, Al, the rate hikes are related to inflation, which we are all feeling the pain of these days. Part of the Fed's responsibility is to maintain a stable economic environment, including inflation and employment. It sets a target inflation rate of 2% per year on average over time.

Currently, the U.S. inflation rate is way over this target. To bring it down, the Fed has increased interest rates, which in turn slows the economy by making money more expensive to borrow.

Al Waller: I get that but at the same time, I've got to add that these rate hikes feel almost – what's the word… “punitive” maybe? – especially when so many people are still suffering from pandemic issues, ranging from job loss, as well as the loss of loved ones.

Catherine Collinson: Indeed, in many ways they do feel painful, but I'm hopeful – because I am an optimist…that economists will be correct in their prediction that the rate changes will help the overall economy and calm inflation in the coming year.

Al Waller: Fingers crossed on that notion, Catherine. Now, let's bring things a little closer to home by examining how these rate changes will affect everyday people – or if you will, the consumer.

Catherine Collinson: The changes affect both consumer borrowing and saving. First, let's talk about borrowing. In a recent survey conducted by my team, we asked people in the workforce about their current financial priorities. More than half (55 percent) cited paying off some form of debt as a current priority – that includes credit card debt, mortgages, student loans, and/or other consumer debt. And with the increase in interest rates, paying off these debts will only get more expensive as our interest rates are rising.

Al Waller: I hear you, and in thinking about credit card debt, any increases in credit card rates could carry a significant impact. According to the Fed, people in the U.S. have more than $4.5 trillion in debt, with more than $1 trillion of that in credit card debt alone. And it goes on to site that the average interest rate on credit cards is closing in on 17%. But then again, let's face it, it may actually be a lot higher for others.

Let me ask you this – do you think those rates could continue to increase?

Catherine Collinson: Unfortunately, yes – which feels almost shocking. Well, it is shocking. Even though interest rates on credit cards are already high, they can go even higher. Credit card Interest rates are typically variable and tied to what's called the Prime Rate. When the Fed Funds Rate goes up, so does the Prime Rate, and in turn, many people's credit card rates. Federal law requires credit card companies to disclose what your rate is and how it's calculated, but there is not a federal law setting a maximum rate.

Al Waller: Well, that's not good news, but I think it does point out that if you do have the means, it underscores the importance of paying off those high interest rate balances before the rates go even higher.

Catherine, you mentioned that mortgage rates have also been on the rise. So, what does your research indicate about mortgage rates and home loans?

Catherine Collinson: Home loan rates are rising too. The average 30-year fixed-rate mortgage for a new home has been on the increase and as of mid -July, it currently sits around 5.5 percent. This is a huge difference compared with January 2021, where it was at a 10-year low at just 2.65 percent – that's according to the Federal Reserve Bank of St. Louis.

So, Al, I was really curious. How does this translate to people's monthly mortgage payments? I did my homework – I went online, and I used a mortgage calculator based on a $200,000 loan. I plugged in the interest rates, then and now – what I found is…this increase in interest rates translates to an increase in monthly payments of upwards of $260 per month – that's for the entire life of the loan. That is each and every month for 30 years because it's a 30-year fixed rate loan.

Al Waller: Well, that's a huge difference. If I can interject, I recall being a newlywed buying our first home, and our fixed rate was – get this…13%. And I mean, we actually felt pretty fortunate to even get that, as rates were even higher.

Let's talk about adjustable-rate mortgages or as they're commonly referred to, as ARMs. How have they been impacted by the great hikes?

Catherine Collinson: Adjustable-Rate Mortgages or ARMs are also increasing. ARMs typically have an introductory fixed rate for a set period such as five, seven, or even 10 years. After that, the rate adjusts. The new rate will be based on a market index, plus a “margin” percentage over that. When the index goes up, your loan payment goes up.

These adjustments are usually made annually but they can be more frequent. Consumers should do some comparison shopping when looking for an ARM. And Al, the devil is in the details. It is vitally important to compare the frequency of the rate adjustments, as well as the caps on the amount that the loan can go up each year – and the amount it can go up over the life of the loan.

Al Waller: Exactly, you really want to be paying close attention to that fine print. I know there are circumstances when one type of loan is more appropriate than another and it’s also highly dependent on the home buyer.

Well, changing course – let's talk about savings-related interest rates. What can you tell us about those?

Catherine Collinson: Looking at the savings side, which is indeed the brighter side, interest rates that are paid on savings vehicles such as money market accounts, savings accounts, and certificates of deposit (or CDs) are also on the rise. However, these increases feel smaller and slower to take effect than what we're seeing with the lending rates.

For example, according to Bankrate.com, the average 5-year CD rate rose from a low of 26 basis points (or .26%) at the beginning of 2022, to 60 basis points (or .60%) at the end of June. So, the good news is that rate more than doubled. However, .60% isn't that great.

Al Waller: I have to tell you, I'm not feeling a lot of love there. But seriously, another important topic related to savings and interest rates is the compounding of interest. It is something I learned early on – that by leaving my investments in their respective accounts, the interest they earned, in turn, increased the base for future interest payments, right?

Catherine Collinson: Al, thank you so much for bringing that up. Compounding returns are so important to building savings over time – over the long term. Let’s give listeners an example. If someone invests $10,000 and gets a five percent annual return, at the end of the year, their account would be worth $10,500. The following year, the interest rate would be based on this new higher amount and so on. These numbers can really add up, especially when we think about things like retirement savings that can continue to grow over decades of an individual's working years.

Al Waller: Great information, Catherine. I think it would be absolutely beneficial for listeners to understand how to navigate these rising interest rates. To that end, what sort of homework will you be assigning to us this week?

Catherine Collinson: Well, of course, Al, there is always homework and doing your homework really pays off. It is worth the investment of your time. Right now – because the interest rate environment is so volatile at the moment, one of the most important homework assignments for us is to simply be aware.

Stay on top of how interest rates are changing and how these changes can impact our financial situation, especially if we're looking at borrowing money for whatever reason – a car loan or a home loan. It is really important to do your comparison shopping and shop for the lowest rate and keep a sharp eye out for any other changes that could be happening to your existing loans or debt.

For example, we touched on credit cards and how credit card interest rates are rising. If you have an ARM or Adjustable-Rate Mortgage, it is also really important to pay close attention to that because your monthly mortgage payments could be going up.

And something that we've talked about on the show before is whenever somebody is in a situation that they're in debt and looking to pay it off, it's always wise to pay off the highest interest rate debt first. That's got to take top priority.

Al Waller: Where can listeners go to learn more?

Catherine Collinson: Well, we've talked about the Fed a lot on this show. So, I want to remind our listeners, its website is www.federalreserve.gov, and it has excellent resources on the topic of interest rates and how the overall interest rate environment works.

Other places where you can go to learn more – one of my favorites is The Consumer Financial Protection Bureau. They offer terrific resources on a number of topics, and their website is www.consumerfinance.gov. State government resources – for example in California, have a Department of Financial Protection and Innovation. That website is – this one is hard to remember so I'll say it once and people can check it out on the transcript of this show – that website is www.dfpi.ca.gov. (Al, we'll have a pop quiz on that after we wrap up the show!)

Other places you can go to learn about interest rates are financial institutions, such as your bank – or if you have a relationship with a financial advisor.

Al Waller: I also encourage listeners interested in this topic to check out past episodes of our podcast on financial literacy and inflation.

As always, Catherine, great to have you with us.

ClearPath – Your Roadmap to Health & Wealth is brought to you by Transamerica Institute, a nonprofit private foundation dedicated to identifying, researching, and educating the public about retirement security and the intersections of health and financial well-being. You can find our weekly podcast on WYPR’s website and mobile app, wherever you get your podcasts, and at transamericainstitute.org.

ClearPath – Your Roadmap to Health & Wealth is produced by Transamerica Institute with assistance from WYPR.

If you have ideas for future episodes, comments, or feedback, please email us at [email protected].

Until the next time, I’m your host Al Waller. Stay safe, be well and thanks for listening.

The information provided here is for educational purposes only and should not be construed as insurance, securities, ERISA, tax, investment, legal, medical, or financial advice or guidance.

Al Waller is a long-time Baltimore native and employment expert with a 30-year career in leading and advising locally and globally based corporations on matters including: Talent Acquisition and Retention, Employee Relations, Training and Development.
Catherine Collinson is the founding president and CEO of nonprofit Transamerica Institute and its Transamerica Center for Retirement Studies, and she is a champion for Americans who are at risk of not achieving a financially secure retirement. With two decades of retirement industry-related experience, Catherine is a nationally recognized voice on workforce, aging, and retirement trends. She was named a 2018 Influencer in Aging by PBS’ Next Avenue. In 2016, she was honored with a Hero Award from Women’s Institute for a Secure Retirement (WISER) for her tireless efforts in helping improve retirement security among women.