Interest rates determined by the Federal Reserve (Fed) are used to determine how much it costs for financial institutions to borrow from each other. As rates go up, those same institutions may raise the rates of their various products. As the Fed drops interest rates, consumer rates typically drop and spending increases.
If you currently have — or are planning to — take out any form of debt like a personal loan, private student loan, mortgage or credit card, understanding how interest rates impact the cost of borrowing is crucial to making an informed financial decision.

How interest rates affect debt nationally

The Federal Reserve sets the national interest rate, but the central banking system of the United States isn’t exactly your traditional federal agency. It is an independent, unique entity that can be beholden to Congress but dictates interest rates and other conditions that affect the national economy on its own.

The Federal Reserve has to balance many conditions when determining the interest rate, including how it will affect the national debt. The national debt is currently at $31.46 trillion, with the majority held by the public in the form of Treasury bills, notes, bonds and other savings vehicles. The federal government is expected to pay interest on that debt, and the amount it must pay rises when the interest rate increases.

According to the Congressional Budget Office, current projections see debt as a percentage of gross domestic product expected to rise in 2024. This is partly because of the amount of debt payments the federal government must make.

At the current rate, debt as a percentage of GDP is expected to reach a historical high in 2031, when it could be as high as 107 percent. That could go higher if interest rates continue to climb or shrink if the rates are adjusted down.

How interest rates affect your individual debt

While the interest rate’s effect on the national debt may have some effect on you — particularly if you hold a Treasury bond — it is more likely that you’ll feel the impact of rate changes on personal debts.

Typically, the Federal Reserve raises interest rates to try and ease the amount of spending to combat inflation and lowers the rate in an attempt to increase spending and kickstart a lagging economy. On average, higher interest rates may encourage saving, while lower interest rates generally encourage spending.

Along with other forms of personal debt, mortgage rates are particularly sensitive to fluctuating interest rates. “Since the Fed has raised interest rates a lot of things have changed,” says Deacon Hayes, financial advisor and founder of Well Kept Wallet. “One of the main impacts has been the rise of interest rates on 30 year mortgages.”

Hayes goes on to explain that when rates are low, the decision to buy is easier. “People could buy a bigger home and afford the payment. If someone would buy today, the size of the home they could afford would be much smaller.”

Similarly, Hayes said that people are less likely to want to sell their home than they previously would have been because of the low interest rates — especially if they locked into a lower fixed-rate mortgage and would rather hold onto that than enter into a higher mortgage rate on a new home.

Like mortgages, credit cards are also indirectly affected by the Federal Reserve’s interest rates. And when the rates go up, consumers may be less willing to use their credit cards.

How interest rates affect your credit score

While interest rates don’t directly impact your credit score, there is the potential for an indirect effect on your score as rates rise. Higher interest rates mean you’ll be paying more in interest accrual which can lead to growing debt if you’re unable to pay down the principal and interest in full each month.

When interest rates rise, it can mean that your payments get bigger and your budget gets tighter. If you miss a payment or are unable to make it in full, you may end up hurting your credit score.

How you can get lower interest rates

While the Federal Reserve sets the benchmark interest rates, financial institutions and lenders set their own rates based on the financial service they offer. Credit cards, for example, will always carry a higher average interest rate than mortgages because one is a short-term, unsecured loan and one is a long-term loan with collateral.

For this reason, it’s important to shop around and compare interest rates through prequalification. Prequalification allows you to see your approval odds and predicted rate offer with no impact to your credit.

Once you’ve prequalified with a few lenders, compare offers to find the company that offers the most competitive rates and favorable terms. Also look out for benefits offered by the lender. It’s common for banks and lenders to award existing members with rate discounts. Lenders also commonly offer discounts for enrolling in autopay.

Also consider rate trends — is it best to take out a fixed-rate loan right now, or are rates predicted to go down in the near future? If rates are predicted to dip, consider an adjustable rate loan so you can potentially secure a better rate down the line.

When it comes to securing a good rate, Hayes also recommends keeping credit utilization under 30 percent. “This shows the lender that you are a low risk because you are not out there maxing out credit cards. This will also make it easier to qualify for lower interest rates on credit cards, home loans, et cetera.”

Bottom line

The Federal Reserve sets a benchmark interest rate, which significantly impacts national debt and individual debt. In short, the more the Fed raises rates, the higher the cost of borrowing becomes. However, when rates decline, products like mortgages become more affordable and market demand subsequently increases.

Keep track of macroeconomic trends and how the Fed responds to market fluctuations to make informed borrowing decisions that won’t put you in an unfavorable amount of high interest debt in the future.