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You might have noticed you’re paying more these days for groceries, gas, clothes, and other things. You might also be hearing about interest rates, mortgage rates, and the Federal Reserve. What do these have in common, and what is the impact on your personal finances?
The short answer is that when inflation is high, the Federal Reserve often raises interest rates to encourage less spending and to keep prices steady. If the economy slows down, the Federal Reserve, often called “the Fed,” may lower rates to make borrowing cheaper and help spur activity.
Keep reading to learn more about the connection between interest rates and inflation, and how they may affect your wallet and finances.
Key takeaways
- Inflation measures the rate that prices increase over
- The Federal Reserve often raises interest rates to combat high
- Higher rates are intended to encourage people to spend less, which may lead to lower
- Changing interest rates may affect your finances depending on whether you have fixed- or variable-rate
What is inflation?
Inflation is a measure of how fast the prices of goods and services increase over time. High inflation means that prices are rising relatively quickly. Low inflation means that prices are increasing more slowly.
What causes inflation?
Inflation can be caused by many factors, including higher costs for raw materials or wages, and greater consumer demand. Inflation may also be affected by steps taken by the government that encourage people to spend more, including tax cuts and lower interest rates.
What are interest rates?
An interest rate is the amount a lender charges to lend a borrower money. Interest on a loan is typically paid back in installments over the loan’s repayment term.
Why do interest rates rise when inflation is high?
One of the goals of the Federal Reserve is to keep the annual inflation rate at about 2%. When inflation is too high, the Fed may raise interest rates to encourage consumers and businesses to spend less.
“Inflation becomes a problem when it is so high it exceeds wage growth and when it is unpredictable, which makes it difficult for consumers and businesses to plan for,” said Li Ma, treasurer, Discover Financial Services.
How do higher interest rates lower inflation?
When the Fed raises interest rates, it increases the cost of borrowing money. As a result, the demand for products may decrease as people spend less. This may help stabilize prices, which limits inflation.
With lower interest rates, it costs less for consumers and businesses to borrow money. This may make it more affordable for people to make bigger purchases, like buying a car or paying for a home, or to borrow money through other loans.
What is the difference between fixed and variable interest rates?
There are two basic types of interest rates: fixed and variable.
Fixed interest rates
A fixed interest rate means the rate will not change for the duration of the loan or for a set amount of time. A fixed interest rate is typically not affected if the Fed raises or lowers interest rates.
One benefit of a fixed-rate loan is that you know in advance how much the overall cost of borrowing will be. With an installment loan, for example, you have one set regular monthly payment and know precisely when the loan will be paid off.
Variable interest rates
The interest rate on a variable-rate loan may rise and fall throughout the duration of the loan. This may change the amount of interest you pay for the money you borrowed.
As a result, even if your minimum monthly payment remains the same, less of your payment would go toward paying down the principal if your interest rate increases. This would mean it may be more expensive and take you longer to pay off your debt.
What are some ways to help combat rising interest rates?
There are several steps you can take to help protect against the impact of higher interest rates. In each case, it is important to understand your specific financial situation.
For example, if you are considering a new loan, you may want to keep in mind that the interest you pay might increase if you choose a variable-rate loan. Instead, depending on why you’re borrowing, a fixed-rate loan, such as a personal loan, might be a better choice when planning your financial future.
If you already have a variable-rate loan or line of credit, such as a credit card, you might consider moving that debt to a fixed-rate loan. By consolidating variable-rate debt into one fixed-rate loan, you may save money on interest and even pay off the debt faster. In fact, 88% of surveyed debt consolidation customers told us they expect to pay off existing debt sooner with a Discover® personal loan.*
“Always begin by taking stock of your financial objectives, obligations, and resources. Then you can use that information to decide how much to borrow, how long to borrow, and what payments you can afford,” said Ma. “If you’re unsure how to do this, you may want to consider getting help from a qualified financial advisor.”
To see how much you might save on interest with a fixed-rate loan and one set regular monthly payment, you can use our debt consolidation calculator. A personal loan for a purchase or debt consolidation might also simplify your finances and help you reach your financial goals. Over 2 million people have reached their goals with a Discover personal loan.