Interest rates and everything else

In short

A friend of mine once told me that interest rates are the weather of money, and I have never found a better way to say it. You have probably felt it without naming it, in the price of a car loan or the payment on a house. The rate on a loan is the price of borrowing. The rate on savings is the pay for waiting, and the two tend to move together over time, though rarely on the same day. Check the rate on your own loans and accounts before you make any big money move. Ask what you would owe, or earn, if the rate changed by one point. Then decide what you can carry. That is all a person needs to start.

The whole of it

What it is

I once watched a neighbor lend his tractor to a man down the road. He did not ask for money, but he did ask for a favor back, and everyone understood the tractor had value while it sat in another man's barn. Interest works the same way. It is the price paid for using something that belongs to someone else, and with money, we count that price as a percent.

If you are holding a savings account, you are the lender. The bank uses your money and pays you a little for it. If you are holding a mortgage, a credit card, or a car note, you are the borrower, and you pay the bank for the use of its money. Same idea, opposite chairs.

The rate itself is a percent of the balance, counted over a year. Ten percent on a thousand dollars is a hundred dollars a year. Simple. You are wiser than you think to ask about it.

How it works

You have probably heard that the Federal Reserve sets rates, and that is close but not quite right. The Federal Open Market Committee, the group inside the Federal Reserve that guides these decisions, sets a target for the federal funds rate, which is the rate banks charge each other for very short loans. The Federal Reserve explains this on its own website, in the section on monetary policy. Banks then build their own prices on top of it.

So a change at the top does not reach you all at once. It moves like water through a field. Credit card rates are often tied to a benchmark called the prime rate, and they can respond fast. Savings account rates move too, but banks are often slow to raise what they pay you. A fixed rate mortgage follows a different road, because it tracks longer term bond markets and not just the short rate the Fed sets.

A fixed rate stays the same for the life of the loan, while a variable rate can change as its benchmark changes. Knowing which one you have is half the battle. I would say it is more than half.

Interest also builds on itself. When you leave your earnings in the account, next year's interest is paid on the old balance plus the interest you already earned. That is compounding, and it works for a saver and against a borrower who only pays the minimum.

The numbers, and where to find yours

Some figures are set by law or by policy, and they change. The current federal funds target range is the current figure, which the official source publishes each year, and you can see it on the Federal Reserve Board website. The current prime rate is the current figure, which the official source publishes each year, which most banks post on their own pages. Savings accounts at insured banks are covered up to the current figure, which the official source publishes each year per depositor, per bank, per ownership category, according to the Federal Deposit Insurance Corporation.

Your own numbers matter more than these. Look at your loan statements for a line called the annual percentage rate, or APR, which is the yearly cost of the loan stated as a percent. Look at your savings statement for the annual percentage yield, or APY, which is what you earn in a year once compounding is counted. Your credit card statement lists its APR right on the front, and the law requires it. If you cannot find a rate, call the number on the back of your card and ask. Nobody minds. It is your money.

A worked example

Let me tell you about a woman named Denise. She owes 8,000 dollars on a credit card, and she also has 8,000 dollars sitting in a savings account. Her card charges 22 percent a year. Her savings account pays 4 percent a year. These are her own plain figures, picked to make the math easy to check.

The card costs her 8,000 times 0.22, which is 1,760 dollars a year in interest. The savings account earns her 8,000 times 0.04, which is 320 dollars a year. Take one from the other, and she is behind by 1,760 minus 320, which is 1,440 dollars a year.

Now suppose rates rise, and her card goes to 23 percent while her savings goes to 5 percent. The card now costs 8,000 times 0.23, or 1,840 dollars. The savings now earns 8,000 times 0.05, or 400 dollars. She is behind by 1,840 minus 400, which is 1,440 dollars. The gap did not move at all.

That surprised her, and it surprised me the first time. The lesson is not that rates do not matter. The lesson is that the two sides of her ledger matter together, and a person who watches only one side can miss what the whole picture says. Denise could use her savings to pay off the card, and then she would owe nothing and earn nothing. Her yearly cost would drop from 1,440 dollars to zero, though she would lose her cushion for emergencies. That is a choice for her to make. She did well to see the numbers laid out. She did not have to guess.

Where it goes wrong

I have known good, careful people who stumbled here, so take no shame from it. The first stumble is looking only at the payment and never at the rate. A low monthly payment can hide a long loan and a great deal of interest. Ask for the total you will pay over the life of the loan.

The second is trusting a teaser. Some cards and loans start with a low rate that jumps later. Read the part of the agreement that says what happens when the introductory period ends. Federal rules under the Truth in Lending Act require lenders to disclose the terms, so the facts are there for you.

The third is forgetting that a rate can change under your feet. A variable rate loan can grow more costly with no action from you. If you have one, know what benchmark it follows and how often it resets.

The fourth is comparing a rate to a rate that is not the same kind. An APR and an APY are not twins. One is a cost, the other an earning, and each counts compounding a little differently.

The last is waiting for the perfect moment. Nobody has ever timed rates with any steadiness, and I would not trust the man who says he can. Work with what you have today, and check again when your situation changes.

Questions to answer before you leave this page

What is the rate on every loan and card you carry, and do you know whether each is fixed or variable? What would your payments look like if a variable rate rose by one full point, and could your household carry that? What does your savings account actually pay, and is the bank passing along what it says it will? If you hold both a costly debt and a cash cushion, have you laid the two side by side the way Denise did? Do you know how much of your savings sits inside the insurance limit at your bank? And when did you last sit down and read your own statements from top to bottom, just to see what they say?