Have you ever wondered how the general economic situation affects your personal finances? In the light of current events in the US economy and in the global economy, this issue is becoming increasingly relevant. The monetary policy of the Federal Reserve System directly affects every citizen, since it regulates the interest rate, on which the interest rates of all other credit companies depend. But if you do not know why this affects you, then you should find out explanation of interest rates to understand.
Unfortunately, more than half of adult Americans know almost nothing about how banks work and why a change in the interest rate changes the cost of loans for each borrower. To be able to take timely measures to effectively manage your personal finances and not commit erroneous actions, you should read the explanation of interest rates and find out how it works.
Money has its value
The Federal Reserve operates as a lender to all other banks. This is the US central bank, which lends money to banks in much the same way that banks lend money to ordinary borrowers. At the same time, other banks must also pay the interest rate for the credit received. This is to ensure that ordinary banks have a supply of money for financial transactions and lending to customers.
The interest rate set by the Federal Reserve determines the value of money. Yes, exactly so – money has its value, like any goods. Explanation of interest rates tells us that the higher the interest rate used in interbank transactions, the more expensive the money. Following the increase in the Fed interest rate, interest rates for ordinary consumers increase too.
The same thing in quite contrary, the opposite direction, if the Fed reduces the interest rate for other banks. So you can see that banks also pay interest on the money used, so they should also give out loans only on the condition that they make money on it.
Thus, the global economy affects every ordinary citizen, although not directly and possibly not immediately, but after a certain short period of time, this effect will necessarily affect.
How exactly do interest rates work?
The interest rate is a percentage that is added annually to the principal loan amount each year. That is, if the interest rate is 10%, then for each year you use a loan of $ 1,000, you will have to pay $ 100. If we say a loan for 5 years, then during this time you will have to pay 500 dollars of interest. The total loan amount for you in this case will be $ 1,500. That is why it is worth paying loans faster if possible. This is true in the case of a simple fixed interest rate.
In addition to this type of interest rate, in many cases, lenders apply a compound interest when interest is added to the base loan amount every year or even every month. In this case, you will have to pay more and more.
In the case of credit cards, a variable interest rate is most often used on a daily basis. In this case, the interest rate is determined by multiplying the daily interest rate on the Balance on your credit card and multiplied by the number of days the credit is used, usually a month period is taken.
That is why it is worth carefully monitoring the use of the credit limit of your credit cards, so as not to get a big debt later. As you see, the interest rate that you will have to pay directly depends on how much you owe. The faster you pay off your debt, the lower your average monthly interest rate.
Explanation of interest rates is that banks charge APRs to capitalize on this and, in turn, pay off interbank loans. So, by lending money to ordinary borrowers, banks and other financial companies receive an interest rate to cover their costs and risks, as well as earn money.
- That is why such high competition in the credit market, which gives some advantages to borrowers. Due to fierce competition, you can choose among many offers, get softer conditions and lower interest rates for a certain period, as well as negotiate with creditors.
- Using loans you stimulate this system, buying now those goods that you could earn after some time. However, do not forget that such an acceleration of getting what you want costs you the money that you pay in the form of an interest rate for the next few months or even years. This means that you should not abuse loans and buy too much and often those goods and services that you cannot afford. This creates a huge national debt of the United States, which amounts to trillions of dollars annually.
Learn more about how loans work
Having received explanation of interest rates, you know how this system works and why this is exactly the case in our financial system. Now you understand that having access to credit, you should carefully use it so as not to harm your personal finances.
Improve your financial literacy and manage your money efficiently. You can start exploring this topic with our financial blog, where you will find all the information regarding loans and personal finances. In addition, you can contact our expert to get advice on these issues.