Part 2: The 3 I's and Your Budget

Welcome to Part 2 of the 3 I's and Your Budget! This post is focused on the I of Interest Rates!

Much like inflation, interest rates have been a hot topic in the news for the last few years! Consumers generally want to pay low interest rates because that means lower interest costs! But what drives changes in interest rates? Why are they intentionally increased? And what does that mean for your budget?

Interest is essentially the cost to borrow money. If you borrow $1,000 at an interest rate of 5% and it is due to be repaid in one year, then you have to not only repay the $1,000 but you also pay $50 in interest for that year. When you look at a simple example like this, the difference between a 3% interest rate ($30) and an 8% interest rate ($80) is only $50 but when you start applying higher interest rates to larger amounts of money being borrowed like mortgages and auto loans, it quickly makes a huge difference!

Interest rates are essentially "set" by a committee within the Federal Reserve. This committee establishes the federal funds rate. The federal funds rate is the rate that banks borrow and lend money back and forth to one another. Of course, banks and lenders are going to charge a higher interest rate than they have to pay so that they can also make money on the interest. When the federal funds rate goes up, lenders increase the interest rate they charge. Let's look at a comparison of the federal funds rate over the last twenty years. (averages for the year)

2003: 1%

2005: 3.2%

2007: 5%

2009: 0.16%

2011: 0.11%

2013: 0.13%

2015: 0.13%

2017: 1%

2019: 1.55%

2021: 0.08%

2023: 5.3% (current rate)

As you can see, in 2007 the average rate was 5% but had increased from just 1% 4 years prior. This rate increase was a driver for the 2008 financial collapse. Why? Nearly 30% of mortgages were variable rate (also called an adjustable rate) in 2007 so when the interest rates increased, the monthly payment on the mortgage increased. The monthly payments were no longer affordable within people's budget and they began to default on their mortgages. To make matters worse, many landlords had used variable rate mortgages and the rents they were charging weren't enough to cover the increased payments so the landlords defaulted.

So why has the Federal Reserve intentionally increased interest rates over the last few years? Their goal has been to curb inflation (inflation was discussed in Part 1). Higher interest rates means the cost to borrow money increases but it also means the interest rate paid on investments like CD's and savings accounts increases. The incentive is twofold for consumers: 1. not to make large purchases since the cost to borrow money has increased and 2. to put their money into savings rather than to spend it. When people spend less they decrease the demand for goods and services which in turn (theoretically) will drive down prices.

There can be numerous affects of interest rate increases on your family budget. If you are currently paying off credit card debt at $250 per month and the rate increases on the credit card then more of your $250 payment is going towards interest rather than the actual debt. If you are in the market to purchase a home when interest rates are high then the monthly payment that works for your budget is going to have less purchasing power. For example, if a $2,000 per month mortgage payment is right for your budget then with a 3% mortgage rate you can afford a $475,000 loan but with an 8% mortgage rate (current rate) that goes down to a $275,000 loan. That is a big difference in the house you are purchasing! Plus, if you are enticed to save more so you can earn the higher rate in those CD's and such, then you will decrease the other spending in your monthly budget. (This is also where the thought process of reducing inflation comes into play.)

In Part 1 we addressed the high costs of certain budget categories, especially groceries and how they impact your budget. Your budget is like a puzzle. Every piece to a puzzle has an intended place. Therefore, when you put a puzzle together you use every piece. When you put your budget together, you want every dollar of your income to have an intended purpose. That purpose needs to maximize that dollar to the fullest which is why you want to be paying the least amount of interest possible so you can be utilizing the dollars towards essential items like groceries, your home, and savings.

Information contained in this post is for educational purposes only and is not considered financial advice.