What Determines Your Student Loan Rates?
Over the last two years, interest rates have been steadily increasing from their low in the 1970s. Most would agree that the U.S. economy has moved out of the recovery period of the recession in 2008, and it has entered an expansion period, where the economy is growing again. But how do interest rates fit into the greater essence of the economy? Interest rates are the basis of controlled (and uncontrolled) expansion or contraction in the economy. since almost every long-term purchase and investment is financed by interest.
Defined simply, interest is the time value of money. Ever heard of this riddle: would you rather have a million dollars today or a million dollars in 10 years? It’s not much of a riddle at all; in fact, if you have heard it, you probably heard it from some finance brat like me who is trying to find a way to prove someone wrong. Regardless of where you heard it, the principle holds true: you would rather have the million dollars now. However, over those 10 years that you would have been waiting to receive your money, you invest your money and earn interest, and at the end of the decade, you have a million dollars and then some. Exactly how much the “and then some” is depends on what the interest rates are over the 10 years that you saved the money. Higher rates mean you are getting more money every year you have it invested, especially if the interest is compounding, which means that the next interest calculation is determined by including the past interest payments. Essentially, the current interest is found by multiplying the interest rates and the sum of the principal and past interest payments.
The higher the rates, the more you get back; that’s what you always need to think about when deciphering new rate changes. The idea behind rate hikes is that higher rates cool down the economy. The factor of the increases and decreases is ultimately the Federal Reserve, sometimes known as the Fed. It controls many aspects of the macroeconomy in the United States. The main control of the Fed is the money supply, which is simply the amount of money in circulation. The Fed will sell government bonds to the public to decrease the money supply, and it will buy back bonds from the public to increase the money supply. The change in money supply has a strong effect on interest rates. When there is less money in circulation, the interest rates demanded increase, all else being equal. This is because less money in circulation means that there is less money to be passed around in the economy or to be put into investments, so higher interest rates make investment opportunities more attractive to consumers and firms. This is exactly how the Fed “cools down” the economy. It causes an increase in interest rates which leads to more saving and investment and less spending and consumption.
Why does the Fed need to cool down the economy though? Well, the answer to that is inflation. Simply, inflation is the devaluation of the currency over time. The United States has experienced inflation consistently for the past 80 years, with varying degrees of intensity. Inflation causes prices to rise over time. One of the Fed’s goals is to keep prices stable, but in order to accomplish that, it needs to counteract inflation. According to economist Irving Fisher, inflation occurs as money supply grows faster than the growth of real gross domestic product, which evaluates a country’s output. Higher interest rates mean more money is stored away in investments rather than being spent, which in turn decreases the money supply and slows the rate of inflation. This is how the Fed keeps prices stable: a lot of cause and effect. A common misconception about the Fed is that they directly control the interest rate. Interest rates, like most things in the economy, are determined by supply and demand and other market mechanisms. The Fed influences the market supply and demand to achieve the rate that it wants to set.
Right now, the Fed is attempting to accomplish exactly what I have laid out above. With inflation rates wavering near 2%, which is the Fed’s target inflation rate, things are looking pretty steady for now. But looking forward, experts predict that inflation rates are due to rise after reported wage increases and tax cuts across the country. As inflation rates rise, the Fed plans to raise the interest rates by buying back government securities. It plans to gradually raise rates to keep inflation and more importantly the economy stable and successful. So next time you pass one of the Federal Reserve branches on a Sunday stroll through your city, make sure to give the Fed a little acknowledgement. It has done a lot for this country and continues to do so.