Interest rates affect your financial decisions, especially when it comes to saving money. It’s the percentage of principal balance earned from deposit accounts or the amount of money that the lender charges.
The Federal Reserve changes the interest rates based on the current situation of the economy to achieve ideal economic growth and it can affect how to save money.
In this article, we’ll discuss why interest rate changes and why a higher interest rate is important when saving money.
Why Does Interest Rate Change?
As mentioned, the Federal Reserve manages and sets the interest rate, also known as the federal funds rate. The banks and other financial institutions use that rate to borrow money from each other for a short amount of time.
The Federal Reserve raises interest rates when the economic growth is good. It prevents the economy from growing too fast as it can result in high inflation. The interest rate is decreased when the economy is not performing well to increase its growth.
Why Is a Higher Interest Rate Important When Saving Money?
A higher interest rate is important when saving money because of multiple reasons, including the following.
It Helps Your Earn More Money on Savings Accounts
If you have a savings account with a high-interest rate, it will allow you to earn more money at a faster pace. For example, if you have two savings accounts and you invest $1,000 in each of them. The interest rate on your savings account “A” is 15 percent and 5 percent on the account “B”.
In such a scenario, your savings account “A” will allow you to earn $150 but you’ll only earn $50 on your account B because of the change in interest rate.
On average, the annual yield on a savings account is just 0.09 percent. Whereas, high savings account rates offer a significantly higher annual yield, which can even reach 1 percent. It’ll affect both your long-term and annual earnings significantly.
So, if you want to earn more money, you should go with a high-interest savings account. It’ll make it easy for you to achieve your financial goals.
Although some high-yield and standard savings accounts have minimum balance restrictions and charge some monthly fees, not all of them have these limitations. Because of their low administrative costs, many internet banks can totally bypass these costly fee and limitations.
Monthly fees, minimum balance requirements, eligibility limitations, and interest rates vary greatly from bank to bank. So, you’ll need to look for multiple available options to go with the one that suits you the best.
It’s also easy to access the funds that you have in your savings account. Most banks offer different methods for this purpose. For example, you can wire your funds to another account, transfer money to one of your linked bank accounts, or withdraw cash using an ATM.
You Can Buy Bonds
Interestingly, bonds and interest rates have an inverse relationship. It means that the prices of bonds decrease with the rising interest rates and vice versa. So, you can buy bonds at lower prices when the interest rates are high.
However, you’ll need to stick to your bonds so that you can sell them when their value increases because of a low-interest rate.
The following are the concepts that will help you understand the relationship between interest rates and bonds.
Value Loss but Only on Paper
Suppose you buy a bond by paying $500 but the interest rates decrease. It’ll also reduce your bond’s total value. If it becomes $400, you’ll lose $100.
However, your loss will only be on paper. In such a case, you don’t need to sell the bond right away and hold it to maturity. It’ll increase the probability of selling your bond to its 100 percent value without losing a penny.
Fluctuation in Interest Rates
The market value of your bonds will fluctuate as interest rates fluctuate. However, the fluctuation in the value of all bond types won’t be the same. Usually, bonds that have a shorter maturity experience nominal changes in their values because of interest rate fluctuations.
Short- and Long-Term Changes
Short-term changes in interest rates don’t usually affect the bond’s long-term outlook. It’s especially true for the investors following a long-term investment plan. The reduced prices of bonds due to the high-interest rate will likely be offset by the decreased interest rates at a later date.
You Can Invest in Stocks
It’s important to note that the changes in interest rates don’t directly affect the prices of stocks. But the actions taken by the Federal Reserve can lead to a trickle-down effect in some cases, which can change the stock prices.
When the Federal Reserve increases the interest costs, the banks also raise interest rates for business loans and consumers. In such a scenario, less money is available to the consumer. Additionally, it can also lead many companies to halt their hires and expansions.
As a result, the value of the stocks starts to decrease. It provides you with an opportunity to buy stocks at low prices and hold them until they increase their value. But it’s important to keep in mind that there is no guarantee that the increase in interest rates will affect the stock prices negatively.
More often than not, the increase in interest rates takes place when the economy is growing at a faster pace. So, the increase in interest rate can also coincide with the bull run.
Therefore, you’ll need to examine the company’s pricing power and the demand for the product or services it offers to determine whether you should invest in it or not.
When Does Interest Rate Change Will Affect You?
If you have borrowed or invested money, the interest rate change will affect you if your contract is based on a variable interest rate. Some types of student loans and credit card balances are usually subject to the variable interest rate.
You can also have a savings account with a variable interest rate if you want. In fact, it will generate more money than a regular savings account with a fixed rate during periods of high-interest rates. However, your earnings will reduce if the interest rate decreases.
When Interest Rate Change Won’t Affect You?
If you have borrowed or invested money with a fixed interest rate, the interest rate change won’t affect you. For example, if you obtained a loan with low-interest rates, your interest payments won’t increase even if the interest rates get doubled.
The same will be true when you lend money to someone. The borrower will need to pay interest that you have decided at the start of the term. But it’ll remain the same whether the interest rate increases or decreases.
The change in interest rate can affect your investments and the way you earn money in different ways. The rise in interest rates provides you with many opportunities to save money but it’s important to stick to your plan and stay focused to achieve your financial goals.
We hope this guide helped you understand why a higher interest rate is important when saving money and what methods you can use to take advantage of an increase in interest rate.
Make sure that you consult a finance professional to build a diversified portfolio. Not only will it increase the probability of earning more money but it will also minimize the risk factors.