What Makes Interest Rates Change Over Time?
Interest rates are like an iceberg. They influence our lives in serious ways as we take on and pay off debt. However, most of us only ever see the tip: a number that is assigned to us by some arcane procedure. This might prompt us to ask: what’s really going on with interests rates–what does the bottom half of that iceberg look like? Why do some people have higher interest rates than others? And why can interest rates for everyone change over time? Let’s explore these questions together with a deep dive on interest rates.
What Are Interest Rates?
If you’ve ever take on any kind of debt, then you’ve probably encountered an interest rate. When you take out a loan or buy something on credit, the lender will often tack on an interest rate as part of your repayment plan.
They do this for two reasons: first, natural economic inflation means that the dollar amount you took out as a loan is worth less over time. So if you take out a loan of $10,000 and then pay it back over the next 10 years, that very same $10,000 is going to have less purchasing power than it did when you first took out the loan. In order to hang on to the same purchasing power, the lender needs to get more money back from you than she originally gave.
The second reason has to do with the fact that almost all lenders have some sort of profit motive. Unless you’re getting a loan from friends or family, you’re probably dealing with someone who lends out money as part of their business. This means that they expect to make some money when the whole transaction is complete. By tacking on an interest rate that is higher than inflation, the lender ensures that she will make some extra money when all is said and done.
Why Do Interest Rates Change?
Interest rates can be likened to the price of a loan. Remember that a loan is not free money. Instead, it’s money that someone is giving you at a cost, just like any other good or service that you might buy.
This analogy might make the fact that interest rates fluctuate even more mysterious. After all, the price of a candy bar stays relatively stable if you don’t count inflation, so shouldn’t the price of loans do the same thing?
Not exactly. Unlike candy bars, loans occupy a special kind of market that is always changing. However, it still obeys the laws of economics. In the case of loans, there is one main economic factor to keep in mind: demand.
What’s the Law of Demand?
Demand represents the desire that consumers have for using a particular good or service. Like many things, demand can change depending on various conditions throughout the world. For example, in 2017 the demand for sun-viewing glasses has skyrocketed. This is thanks to the eclipse on August 21st. Although sun-viewing glasses existed long before the eclipse, having a major event gave many people a reason to buy them. Hence, a rise in demand.
Demand also exists for loans. In the debt market, the demand for loans largely depends on how confident consumers are that they can pay that debt back, and how eager they are to make big purchase. This means that interest rates will rise as the overall economy improves. As people land more jobs and get the raises that they want, they’re more likely to start thinking about buying a home, getting a new car, or making another big purchase that requires going into debt with a loan.
Lenders see this increased demand and respond to it in kind by increasing prices. That is, they increase interest rates on the loans that they offer as demand goes up. Lenders are able to do this because, for them, business is booming. When demand is high, consumers are willing to pay a little extra for goods, so they’re more willing to pay higher interest rates.
Likewise, when demand for loans is low, interest rates will go down. A decrease in interest rates is the lender’s way of responding to poor business: bring the price of loans down in order to sell more.
Different Rates for Different Folks
Demand changes interest rates in very broad terms as economies change over time, but this isn’t the only way that interest rates differ. Sometimes two people can walk into the same bank and ask for the same loan, but walk out with different interest rates. Why is this?
Remember that lenders are looking out for themselves. Typically, lenders want to be very careful about who they lend to. They like lending to people with high credit scores because these people are more likely to pay loans back on time. However, lenders aren’t opposed to lending to people with bad credit. In order to account for the additional risk that they are taking, the lender will often charge a higher interest rate to the borrower. If you find that you’re constantly being charged a higher interest rate for loans thanks to your credit score, it’s a good idea to repair your credit and get better deals. Tips and guides for building credit are available at our credit score resource center.
By understanding how interest rates change over time, you can watch loan markets closely and find the best deal when you’re ready to make a big purchase.
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Nick Cesare is a writer from Boise, ID. In his free time he enjoys rock climbing and making avocado toast.
This post was updated December 19, 2017. It was originally published August 19, 2017.