If you open up your newspaper, or click on your favorite publication's website, and you turn to the business section, you will often read news stories about interest rates. You will learn about what central banks are doing, how they will impact a certain segment of the marketplace, what the banks will do in response and, if the reporter gets around to it, how you will be affected.
All over the world, since the global economic collapse, central banks have imposed historically low interest rates – some countries have even adopted subzero interest rates to spur growth.
These often record-low interest rates have been passed onto the finance industry. Although customers will receive pittance on their savings accounts, these same banking clients will receive lower mortgage interest rates. This means that their mortgages, debts and other loans will be more affordable, a time when every penny (or nickel; depending where you reside) counts.
Depending on your personal financial situation, you may either scoff or accept certain levels – high or low – of interest rates. If they are low, you could be disappointed in your rates of return on your savings account but pleased that your mortgage payments are smaller. If they are high then you may be pleased by the high rates of return on your savings account, but disappointed that your mortgage payments are much higher than you initially anticipated.
Whether they are high or low or at historical norms, you will come to realize one thing in your pecuniary endeavors: interest rates on loans and savings accounts can earn or save you money.
Let's first take a look at rates on three distinct types of savings accounts:
Basic Savings Accounts
Nearly all of us have a basic savings account; as soon as we turn 18 we open one up.
When you launch a checking account for your daily banking needs then you are likely to establish a generic savings account as well that is offered by your bank. As part of a financial institution's marketing efforts, these accounts may also be referred to as "regular savings," "day-to-day savings" or "goal savings."
Once you start to deposit money into the account, you will be provided with interest.
This is because the money you put into the account is then loaned out to other customers or used by the bank as capital. For this, you are rewarded with interest, which varies based on the type of account you have and what bank you are a client of. The interest rates for savings accounts are created to maintain pace with inflation so a small percentage will be earned every month.
As time goes by, you will grow your savings with compound interest (reinvesting the interest you earn). If you want to have a glimpse of what your savings account will look like in the future then utilize the rule of 72. This is a fast method of calculating how long it will take to double your money through compounding. All you have to do is divide the number by 72 by the annual interest rate you plan to earn on your savings.
For example, your savings account comes with annual return of two percent so when you use the rule of 72 then you will have doubled your money in 36 years.
Money Market Accounts
A money market account (MMA) is similar to a savings account, except that it typically provides users with higher amounts of interest. The difference is that a minimum deposit and balance will be required, and can range from $1,000 to $100,000. These accounts also offer the customer with limited check-writing ability and are insured by the federal government.
You must be aware in advance that you may have to pay a monthly service fee for an MMA. For example, if you do not meet your bank's minimum balance requirement of $1,000 then you may have to pay a $10 fee for the month.
Simply put: the higher the minimum balance is the higher the monthly fee is.
Certificate of Deposits (CDs)
A certificate of deposit, otherwise known as a CD, is a savings certificate that comes with a fixed interest rate and a fixed maturity date. What makes CDs attractive is the fact that they offer customers higher rates of interest than a regular savings account or money market account.
It should be noted that the investment vehicle does restrict access to the funds until the maturity date of the deposit. You will face an early withdrawal penalty if you want to access the money.
There are three primary types of CDs:
- Small CDs ($100,000 or less)
- Large CDs ($100,000 or more)
- Jumbo CDs ($250,000 or more)
The length of a CD can range from 30 days to as long as five years.
This is a great savings tool for those who do not need immediate access to their deposits. If you do not need to touch a deposit of, for example, $5,000 for about a year or two then a CD is a superb monetary choice in order to garner a better rate of return. The interest rate may also be higher than price inflation at the grocery store, at the gas station or at your local barbershop.
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Interest Rates on Loans
Now, let's take a look at interest rates on loans:
Fixed-Rate vs. Adjustable-Rate Home Mortgages
It is true that acquiring your home will be the biggest purchase and investment decision you will ever make in your lifetime. Since your house or condominium will come with a six-figure price-tag, you need to perform your due diligence and necessary research to ensure the right course of action is taken, especially when it pertains to the mortgage interest rate.
As potential homeowners search for their next home and the right mortgage, they will often come across two types of mortgages: fixed-rate home mortgages (FRM) and adjustable-rate home mortgages (ARM)
What is the difference exactly?
Fixed-Rate Mortgage (FRM)
Regularly referred to as a so-called vanilla wafer mortgage loan, a fixed-rate mortgage is a fully amortizing mortgage loan that establishes an interest rate that remains the same throughout the entire amortization period.
For instance, if you apply for a mortgage with a 25-year amortization period then you will pay a mortgage interest rate of five percent. For the term of the loan, it will stay at that five percent rate.
When you are in an environment of low interest rates, many homebuyers will select the fixed-rate. On the other hand, if mortgage rates are too high then they may select the other option: an adjustable-rate mortgage.
Adjustable-Rate Mortgage (ARM)
An adjustable-rate mortgage, otherwise known as a variable-rate mortgage, is a mortgage loan with an interest rate that regularly changes based on an index that reflects the cost to the lender of borrowing on the credit markets. The mortgage could be provided to the borrower based on the lender's standard adjustable-rate or base rate.
During your quest to locate the best ARM, you will often come across two specific numbers: the first number suggests the length of time the fixed-rate is applied to the loan and the second number may offer you a floating rate.
For instance, 2/23 ARM means a fixed-rate for two years and a floating rate for the remaining 23 years. Or, as another example, 4/1 ARM means a fixed-rate for four years and then a variable rate that is modified every year. Indeed, these are a lot of numbers and formulas so be sure to always clarify with a mortgage expert.
Homebuyers will often choose an ARM when mortgage interest rates are too high due to the fact that it will have a lower initial rate that makes it far more affordable. With that being said, when the rates go up so will the monthly adjustable rates.
Ultimately, mortgage borrowers must attempt to learn this intricate industry and weigh the pros and cons of deciding to opt for an adjustable-rate or a fixed-rate mortgage. As you will learn, there is a trade off when you select a mortgage that comes with risk and reward or just certainty.
Interest rates make the world go round. Like market prices, they can send signals to businesses and consumers, importers and exporters, buyers and sellers. Borrowing or lending money can be cheap or it can be expensive based on what level the policymakers at the central bank and financial institution set the interest rates at.
For the average person, however, they are just concerned about what rate of return they will receive on their savings accounts, or how much their monthly payments will be in regards to their monthly mortgage interest payments. That's all what really matters to most people.
You can make money or save money through the power of interest rates. As a consumer and as a borrower, you just need to know how to protect yourself or how to take advantage of your financial options in the marketplace. Once you do, you'll be glad these rates exist.
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