Interest Rates…

Disclaimer: None of this is advice.; it’s for educational purposes only. Questions and/or thoughts? Drop me a line and let’s discuss.

Also: Yes, we all know there are so many more details surrounding these subjects, but my goal is to start at the foundation and build; give everyone a chance to learn. Meaning, go easy with the "yeah-but" responses.

Interest Rates Explained (Minus the Boring Bits)

“Interest rates” are two words that have garnered significant attention and commentary recently, with the volume around them reaching screeching levels at times. And while the topic may seem as thrilling as a lecture on tax codes, it’s essential to understand their importance because of how interest rates play such a crucial role in our financial lives, impacting everything from our mortgage payments to our daily coffee budget and nearly everything in between.

Ok; So, What Is an Interest Rate?

Think of an interest rate as the cost for borrowing or lending money. Want to borrow $1,000 from the bank? Cool—but they’ll want something in return for providing the $1000. That “something in return” is the interest rate. On the other hand, if you deposit your money in the bank (a.k.a. put it in a savings account), they pay you interest for the privilege of holding onto your cash. It’s like your money is doing side quests while it sits in the bank…which we’re cool with because that’s where our “interest” payment comes from (we'll dive into more details on this topic another time). This scenario illustrates borrowed money, or a “loan,” where the principal is $1,000, the interest rate is 5%, and the term, or repayment period, is one year. But what if we extend the term to 2 years? Now, we need to consider whether we’re discussing “simple” interest or “compound” interest. Wait, there are two types? Yes, but let’s focus on “simple” interest for now. With a 2-year term, you have double the time to repay the loan, which may result in lower payment amounts if the loan is paid back with individual payments versus all at once at the end of the term.

Consider an interest rate as the cost of borrowing or lending money. If you want to borrow $1,000 from the bank, that's great—but in return for providing that amount, the bank will expect something, and that "something" is the interest rate. Conversely, when you deposit your money in a savings account, the bank pays you interest for the privilege of holding onto your funds. It’s as if your money is embarking on side quests while it rests in the bank, generating interest payments for you (we'll delve into more details on this topic another time).

Real-World Example (Minus the Math Degree)

Let’s say you borrow $100 with a 5% interest rate and the whole amount is due after one year. Meaning, you’ll owe the $100 you borrowed plus the $5 you owe in interest. That interest of $5 is the “cost” the bank is charging you to have that $100 right now. Maybe it’s a good interest rate, maybe it’s not (the “interest rate” we’re charged when we borrow money is kind of like a grade we’re getting on our financial health at that specific time; but lets hold off on that for right now; that’ll sidetrack us a bit so we’ll dig into that elsewhere). But let’s say you don’t borrow the money but rather intend on “saving” the $100 in an account where the institution pays you interest, meaning the bank is paying you for you to keep your money in that account while they allow someone else to borrow the funds (one of the ways banks generate revenue…make money). You save the $100 in the account, leave it there, and the bank will pay you interest. Yes, that’s an incredibly simplistic view but it illustrates the concept.

So who’s simple’s big brother?

Compound Interest: The Magical Money Multiplier

Ah, compound interest—the closest thing to financial wizardry most of us will ever experience. It’s like your money had offspring…and then that offspring had its own offspring…on and on and on…and suddenly you have a whole family reunion in your bank account. (What an odd way to phrase it.)

Wait, What Is Compound Interest?

Let’s continue with our example from above: Compound interest is basically interest on your interest. It’s money that earns more money, simply by sitting there looking pretty.

Imagine you put $100 in a savings account that earns 10% a year. After one year, you have $110. Cool; we like.

But in year two, you don’t just earn 10% on your original $100—you also earn 10% on the $10 you already earned. That’s an extra $1 at the end of year 2. True, it doesn’t sound like much now, but keep going and it grows and snowballs.

Simple vs. Compound Interest (a Quick Comparison)

This table…this is the power of compounding.

Year	Simple Interest	Compound Interest
1	$110	$110
2	$120	$121
3	$130	$133.10
5	$150	$161.05
…30	$400	$1744.94

(Simple Interest: "I don't work weekends." Compound interest: "I do.”)

The most significant factor? Time. Time serves as the ultimate superpower, unlocking the potential of compounding interest. When you combine this with consistent contributions to your account over the same duration, the results can become truly remarkable.

Why Should You Care?

Because interest rates stick their noses into every part of your life; they like attention.

• Buying a house? Higher rates = higher mortgage payments = maybe no granite countertops.

• Credit card debt? That 20% rate is why your $50 pizza turns into a $65 regret.

• Saving money? Higher rates mean your savings actually earn something.

Why Do We Want Compound Interest When Investing?

Because compound interest is how people build wealth while sleeping. It’s the reason why:

• Starting investing early beats starting big.

• Saving even a little can add up to a lot over time.

• Your future self will sing praises to your present self.

Who’s in Charge and Controls These Things?

Enter: The central bank (a.k.a. The Federal Reserve in the U.S.), which adjusts interest rates like a thermostat for the economy.

• Economy too hot (a.k.a. inflation)? They raise rates to cool it down.

• Economy too cold (a.k.a. recession)? They lower rates to heat things up.

They basically try to find Goldilocks with the economy, trying to keep things just right but that’s a rather challenging task with so many variables at play. What variables? That's another one we'll have to revisit; that's just too much to cover at once. But all those variables is precisely why forecasting economies is so difficult; the number of those variables at play in conjunction with people's behavior creates an incredibly complex equation to solve.

The Simple / Compound Interest Healthy Bits

So, what does all this mean? Basically, interest rates are pivotal in shaping economic development, and the ongoing pandemic has resulted in continued historically low rates. One of the primary objectives of maintaining these low rates is to stimulate borrowing. (We will explore this topic further when we examine how different types of borrowing—be it by businesses, individuals, or governments—impact economies in both the short and long term.)

The rates are essential for fostering vibrant, diverse, growing economies, and they are integral to nearly every form of economic and financial analysis, which is why they are frequently discussed across various contexts. While the topics and concepts surrounding interest rates may seem complex, the foundational principles are quite simple and straightforward.