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Why Do Interest Rates Change? 3 Key Factors

Posted by Yvonne Talbott Scoggins on December 17, 2020

Why Do Interest Rates Change? 3 Key Factors

Nothing in life is free, as the saying goes—and that includes borrowing money. Fortunately for consumers, interest rates (the cost of borrowing money) have been low for the past decade and are likely to remain low for several years as the economy recovers from the COVID-19 pandemic. Lower rates mean greater numbers of individuals and corporations will be likely to borrow and spend more money in the short term.

However, interest rates are dynamic and will inevitably rise at some point. Understanding the factors determining interest rates can help you decide on the best time to finance a purchase, pay off a loan, or refinance a loan. In this blog post, we’ll answer the question, “Why do interest rates change?” by exploring 3 key factors for these fluctuations.

Wondering how interest rates will affect your specific financial circumstances? Schedule a call with Bay Point Wealth today to walk through your financial situation.

What causes interest rates to change?

1. Supply & Demand

Supply and demand is the primary factor that serves as part of the answer to the question, “Why do interest rates change?” The supply of funds available from lenders combined with the demand from borrowers can have a substantial effect on interest rates. For example, as consumers, when our wallets are tighter, we have less bandwidth to buy products and services. This funding squeeze can lead to a decrease in demand and cause businesses to suffer.

Money is the lifeblood that circulates throughout the economy. Governments analyze money supply and develop policies around it that include controlling interest rates or increasing or decreasing the amount of money flowing through the economy for optimal health.

2. Economic Stagnation

Building on the previous point, a stagnant economy is another key factor in determining interest rates. If there isn’t enough money moving through the economy, the Federal Reserve System (America’s central bank) will typically lower interest rates to stimulate economic activity. As a result, banks will be more likely to lend funds to consumers, who will then have more money in their pockets to make purchases and contribute to economic growth.

The Federal Reserve takes this approach because it operates under a mandate from the United States Congress to promote employment, support price stability, and keep interest rates at a moderate level over the long term.

3. Inflation

In other instances, the central bank will raise interest rates in response to concerns about inflation (the increasing cost of living and doing business). Higher interest rates reduce borrowing and lending, and motivate investors to save. In turn, the reduction in the flow of money slows the economy and lowers inflation.

The central bank will typically provide an indication to investors in advance of such rate hikes. Anticipating interest rates to rise prompts investors to hold shorter maturity bonds, positioning themselves to have the capital to invest in new issue bonds after interest rates have climbed.

Make Smart Financial Choices By Partnering With Bay Point Wealth

The landscape around interest rates is complex, so it can be helpful to speak to a financial advisor if you have questions about what causes interest rates to change and when the time is right to make certain financial decisions as a result. Proper planning can help you reach your goals in the most financially sound and efficient way possible.

At Bay Point Wealth, we’ll work with you on a personalized financial plan, projecting the growth necessary for your portfolio to thrive so your money will last a lifetime. We’ll also advise on your investments, considering factors like interest rate and inflation risks to build a portfolio with the appropriate amount of risk for your financial situation.

If you’re ready to make a plan for your financial future, schedule a call with us today.

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Topics: Financial Planning