While interest rates might only seem to come into play when you’re looking to put your cash into a savings account or certificate of deposit or when you’re trying to get a home loan or credit card, interest rates often have a larger impact upon economies than you may realize. And while the effect interest rates have on economies might seem beyond your scope of control or concern, it might be surprising to find that it can have a very direct impact upon your life and personal finances.
When you hear in the news that interest rates have dropped half a percent or a percent over the last month, you might think to yourself, “Big deal. What good does a measly percent do? It can’t have that big of an effect on the economy.”
However, you might be surprised by just what a percentage point interest rate reduction or hike can have, especially over time. If you don’t believe it, just add another percentage point to a 30-year, $200,000 fixed-rate mortgage, moving it say from 4% to 5%. Make such an adjustment and you could be talking about adding more than $40,000 to the cost of that mortgage over time. So you can only imagine what a such a jump could do for lending institutions and the economy as a whole, and this is only one way in which interest rates could affect an economy — here are a few more.
Since we’ve begun with the mortgage/lending example, let’s continue looking at that example and how it can affect an economy. With lowered interest rates, there is often a correlating interest by consumers to borrow money for things like mortgages, cars, boats, and similar big ticket purchases since money is cheap. This means that there is more money being pumped into the economy to be spent on all types of things. This can increase demand for products, which in turn could in theory create jobs and improve the economy. The ideal situation is where those products are made and sold in the economy because believe or not, production is important!
An example of this might be the US FED currently holding interest rates near zero in hopes of pushing banks to lend to consumers and businesses, and in turn stimulate the economy. Its a blunt tool. This process however, can often take time to begin showing results, and the current state of the economy can also dictate the length of time it takes to have an effect or how much of an effect cheap money can have upon the improvement of the economy.
By pushing interest rates higher, governments can often slow the amount of money being lent, thereby reducing the amount of money in consumer’s hands, and in turn slowing the growth of the economy
So when money is cheap, unless there has been a huge mortgage debacle to scare banks witless about lending, there might be a correlating increase in home sales. In the earlier example, we looked at just how much difference a single percentage point can make in the cost of a mortgage over time. So you can understand how much more attractive purchasing a home is when mortgage rates are at three or four percent rather than six or seven. We are talking about tens of thousands of dollars in difference or more depending upon the size of the mortgage, over the loan’s term. Had it not been for the subprime mess and all the foreclosures across the US, we would probably been seeing a rise in home sales as mortgage rates fall.
You might be wondering how this would affect the overall economy. Well, when homes are selling, Realtors (and there are a lot of them) are making money, and more Realtors are needed, creating jobs. The homes that are being purchased require bank officials (lenders, appraisers, etc.) to be working to process loans, surveyors are needed, as are home inspectors, home repair services, title services, and similar people involved in the purchase process, creating the need for even more jobs. Then as equity is built in the home, homeowners may have the option to borrow more money against that equity to make more purchases, which can create the demand for more jobs, further helping the economy.
Savings & Investments
When interest rates are higher, it might mean good things for you, but as already mentioned, it could also slow the growth of the economy. As consumers begin to realize that their savings could be earning them five or six percent in a bank account (like they are in Australia), rather than going out to splurge and spend that money, they may instead tuck it away in a savings account or certificate of deposit for several years in order to let that money grow and earn more money rather than spend it. In the late 1970s and early 80s, it wasn’t unheard of to be earning interest at rates in the teens. So you can see how tucking away money in interest bearing accounts could have been an attractive option but could also act to slow the growth of the economy.
Homes aren’t the only area in which interest rate trends can have an effect. When interest rates are low, lending for new businesses might be more attractive because the cost of lending is low. The ability to get a loan to start up a small business can in turn create jobs and help boost the economy. There’s loads of small time startups who begin on a shoestring and bootstrap along the way rather than borrow. So for them, interest rates don’t affect them so much.
Similar to new businesses just getting their start, interest rates can also affect the amount of money businesses have to expand and grow. When cash is available at cheap interest rates to be lent to businesses searching to expand their operations, those businesses’ expansion efforts could result in job growth. Provided that these new jobs aren’t being filled overseas the job growth puts money back into the economy through the new job recipients spending their paychecks and paying taxes to fund government spending programs, infrastructure repairs, and similar government work and services.
For some good reading at the layman’s level about how economies work I would suggest Peter Schiff’s book ‘How An Economy Grows And Why It Crashes’.