How interest rates are determined

You need to know how to calculate the interest you'll get by leaving your money on deposit for a certain amount of time, but it's also good to know how financial institutions arrive at the interest rates they advertise.

Interest rates are affected by a number of factors. The Federal Reserve, which is charged with maintaining the stability of the nation's financial system, raises or lowers short-term interest rates in an effort to maintain that stability. The Fed regularly takes these actions in response to economic ups and downs that the country goes through on a fairly routine basis.

Regular interest rate adjustments

When the economy is growing -- companies are profitable, unemployment is low, and consumers are spending money -- short-term rates are raised to keep the economy from building too fast and risking inflation. Inflation is when too much money chases too few goods and services, driving prices upward. Raising interest rates slows the economy. Higher interest rates mean higher borrowing costs for individuals and businesses; and that usually means there's less money to spend elsewhere.

The Fed will lower short-term rates when the economy is contracting -- or slowing. Lowering rates makes it less expensive to borrow money. Consumers and businesses can afford to buy more products and services. That speeds up the economy, keeps people employed, and keeps the economy from sinking into a recession. A recession occurs when consumers get tight-fisted with their money and don't buy the products and services that keep companies afloat and workers employed.

When the Fed cuts short-term rates it is cutting the rate that banks charge each other to borrow money. Those cuts are eventually passed on to businesses and consumers. The same thing happens in reverse when the Fed raises short-term rates.

Other factors and their impacts

Other factors affect interest rates, too, but on a more irregular basis. A crisis involving the foreign oil-producing nations, for example, could have a major economic impact that could affect interest rates.

Long-term interest rates aren't affected as quickly by economic conditions as are short-term rates, but there is a trickle-down factor and they reflect the impact eventually.

What works for you as a saver works against you as a borrower. When rates are high, you're earning a hefty amount of interest for your deposits, but you're going to pay a high interest rate if you need to borrow.

When rates fall, you don't get much interest on your savings, but it's a lot cheaper to borrow money.


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