By: Laura M. Sands

Overview:


Daily, reports of changing rates set by the Federal Reserve Bank are discussed in financial circles. How does the Federal Reserve set interest rates and what does this mean to the average consumer? Understanding how interest rates are determined helps individuals develop confidence in investing, maintaining credit and spending money.

What is an Interest Rate?


Interest refers to the amount of money charged for the use of money that has been borrowed. For instance, if someone borrows one hundred dollars and is charged ten percent interest for the benefit of doing so, then the borrower must repay one hundred ten dollars. The one hundred dollars, of course, being the principle amount borrowed and the additional ten dollars accounting for the interest that the debt accumulated.

Types of Interest Rates


Interest rates are represented as percents and are used to compensate lenders for loaning money, as well as for the willingness to take a risk in doing so. Simply, interest rates can be viewed as the price a borrower pays to receive a loan or the earnings that a lender receives for extending a loan.

Interest rates generally fall into two categories — the prime rate or the LIBOR. A prime rate is the rate that banks charge large-scale borrowers with a good credit rating, while a LIBOR refers to the rates banks that participate in London's money market extend to one another for deposits deemed to be short-term.

How the Federal Reserve Bank Sets Interest Rates


Comprised of twelve federal banks in different regions, the Federal Reserve Bank, commonly referred to as the Fed, sets the American monetary policy. Although the name may cause some to believe otherwise, the Federal Reserve Bank is not a government entity. It is, instead, a privately owned organization. The twelve member banks meet a total of eight times per year unless a major economic crisis occurs, which may cause them to hold additional meetings. During these meetings, the interest rate that will be charged on the money lent to other banks is determined according to the amount of money circulating in the economy and inflation.

Determining a True or Real Interest Rate


The interest rate offered does not always calculate according to the actual rate of which money is being repaid. Instead, it is important to consider the cost of inflation and how the rate is being affected at that precise time. In order to determine this, one would subtract the inflation rate from the interest rate given. The sum of these two numbers exposes what the true or real interest rate actually is.

The Importance of Interest Rates


Based on the supply and demand of money, when interest rates are high consumers are more likely to save money instead of borrowing. Conversely, when interest rates are low, consumers borrow more money while saving less of it. Lower rates also translate into businesses investing more. As rates rise, less money is spent on major purchases, such as cars and houses. Overall, in setting interest rates, the Federal Reserve Bank inspires trends in the economy that affect everyone.