Over the past few years, you have probably heard about interest rate fluctuations when hearing about mortgage rates or other loan rates. While we hear how interest rates impact the economy overall and even specific segments like the housing market, it can be confusing to determine how to make financial decisions based on current interest rates.
If you are trying to figure out what the current interest rates mean, if it is a good time to borrow money, or if it is a good time to lend money, having a basic understanding of interest rates and an acknowledgement of your beliefs and risk tolerance is a good starting point to make the best financial decisions for yourself.
What do high and low interest rates mean?
When interest rates are high, that means the price of borrowing money is high. If you need a loan of any kind, you will have to pay it back with more interest than if interest rates were low. For example, if interest rates are extremely low at 1%, you could borrow $100 and pay back only $101 to include the interest. If interest rates are extremely high at 50%, borrowing that same $100 would cost you $150 to cover the interest.
If interest rates are low, borrowing money is inexpensive. Lenders receive less interest for lending out money, so there is less incentive to lend. When interest rates are high, lenders have a high incentive to lend money because they will receive a lot more money than they initially lent to the borrower.
Are certain interest rates bad?
No, but interest rates impact what financial decisions you make. To put it as simply as possible:
If interest rates are low, borrow money.
If interest rates are high, lend money.
We cannot always plan our lives precisely enough to always follow these rules, but when we can, we enjoy more financial benefits. For example, the average mortgage interest rate in 2021 hovered around 3%, a very low interest rate. Patrick and I decided 2021 was a good time to buy a home in part because interest rates were so low. It meant we could take out a lower mortgage than if interest rates were higher because we only needed to borrow enough money to cover the mortgage and its 2.75% interest. Interest rates are now slightly above 7%, so the same mortgage would cost a lot more.
This makes it sound like low interest rates are good and high interest rates are bad, but that is only the case when you are borrowing money. On the flip side, if you are investing money into high-yield savings accounts (including your emergency fund) or Certificates of Deposit, a higher interest rate is good. When mortgage rates were so great in 2021, high-yield savings accounts were only receiving about 0.5% returns. This means if you invested $100 in a high-yield savings account, you would only receive $0.50 in interest on it for an entire year. Now, interest rates are rising, and high-yield savings accounts receive greater returns, allowing these accounts to grow and experience compound interest more quickly.
What is a high interest rate?
The current interest rates around 7% feel high because of the period of low interest rates we experienced in 2020 and 2021, but historically a 7% interest rate is not particularly high or low. While it makes a mortgage much more expensive than it is at a 3% interest rate, it is still far below historic interest rates. Average mortgage rates from 1971 to 2023 were 7.71%, putting current interest rates near the average. In the 1980s, average mortgage rates were higher than 10% and sometimes even exceeded 15%!
In other words, it is not a particularly good or bad time to borrow money to buy a home. It is also not a particularly good or bad time to lend money to a homebuyer. It feels like a great time to lend money since returns on lending money have increased compared to the previous few years, and it feels like a bad time to borrow since the cost of borrowing is higher than the past few years. But these are simply our recent reference points rather than historical average rates.
While mortgages are often used as a major indicator, interest rates vary for different types of loans. Loans that are viewed as riskier or that do not offer collateral (such as credit cards) are often higher than loans viewed as safer according to lenders. While interest rates fluctuate constantly, you can always look up current rates to determine whether a particular interest rate is a good deal for you.
Should I borrow with current interest rates?
A general cutoff to determine whether borrowing money is worth the cost is to compare the interest rate you would pay for borrowing the money to the return on investment you might receive if you invested the money in an index fund. If you look at average returns, you will see that the current interest rates in the 7% range are truly in the “squishy” zone: You are likely to receive better returns on investment over time, but you certainly may not over the length of the loan if it is something like a five-year car loan.
For reference, here is an easier math problem: Our mortgage has a 2.75% interest rate. High-yield savings accounts currently offer 4% interest rates. We technically have the money to pay off our mortgage early, if we wanted to do so. Should we?
Absolutely not! A near-no-risk investment is growing faster than the mortgage. We should let our money grow other money and slowly pay off that mortgage.
However, if we had a 7.5% mortgage, the math problem is a bit more complicated. The interest rate is higher than safe high-yield savings accounts and most CDs. However, for a 30-year mortgage, I would likely still pay it off slowly, betting that investing in an index fund would bring me higher returns than 7.5% since the historic S&P 500 average annual growth is above 9%.
To change the situation slightly, assume we had a 7.5% car loan over five years. Five years is a much shorter interval of time where it would be imprudent to assume investments would receive the market average above 9%. Returns on index funds over five years could be 25% or they could be negative. The market fluctuates over the short term but grows over the long term, and five years is not long term. As a risk-averse person, I would pay off the 7.5% five-year car loan if I had the cash. A riskier investor may not.
We all make different decisions based on our risk tolerance. For me, a short-term loan is not worth the risk of market fluctuation, but I trust the market enough to recover from any downturn for a long-term loan. Your calculations will likely vary from mine, but you have to make a choice that allows you to sleep well at night without worrying about your money.
Comments