If you’ve taken out a mortgage, auto loan, or even just own a credit card then there’s a good chance that you intimately understand the fundamentals of interest rates. This is how it works, you borrow x amount of money that you pay back over an agreed upon period of time. Now because the creditor or financial institution is in essence fronting you money that you don’t have at the moment, then in return you pay the money back in installments at an agreed upon percentage.
This gives the borrower the opportunity to space out large expenses into more affordable chunks and gives the lender the opportunity to make a little money for fronting the entire cost. Often these occur on fixed interest agreements, but you’ve probably noticed that financial institutions are pretty frequently changing their interest rates, fixed or flexible, which begs the question: why do rates fluctuate?
Supply and Demand
A fundamental part of any capitalist economy, supply and demand are big factors in shifts in interest rates. If there is high demand for access to loans or lines of credit, but actual availability of these funds is low, interest rates will be higher. Accessing this money or credit line is valuable and more difficult to get; if you do get it, you are getting it at a higher cost because there is less of it.
On the other hand, if there is a wealth of access to loans or credit lines interest rates will go down because they are in lower demand. I.e. less exclusive, easier to get and therefore less “valuable”. Remember this is a value assessment not a reflection of how valuable a loan or credit line might be to a specific individual, but rather its relative value and accessibility in the context of the entire market.
Supply and demand are not the only forces at play when it comes to interest rates, Governmental regulations also play a part in fluctuation interest rates. For example, during the economic recession that took place late last decade and continued into the early part of the 2010’s, an institution called The Federal Reserve influences interest rates through the buying and selling of US securities, helped lower the interest rate to encourage borrowing in a stagnant economy by buying up securities and giving banks more lending power. Thus allowing interest rates to stay low.
If the government sells securities this increases interest rates. When banks have less money to lend; lending becomes less accessible and more exclusive. In essence, the US government, (advised by The Federal Reserve) increases or decreases rates based on an assessment of the health of the economy by using their buying and selling power to grant financial institutions more or less money at given times. Typically in a thriving economy, borrowing will be a little more expensive because interest rates are higher, while in a struggling economy rates will be lower.
High inflation rates are often tied to an increase in interest rates because the value of money today under high inflation will be much less valuable in the future. In an attempt to recuperate some of that money when lending, lenders will charge higher interest rates.