Why do interest rates go up? Interest rates usually rise when lenders demand more compensation for inflation or risk, when demand for borrowing increases, or when the Federal Reserve raises its policy rate to keep inflation and economic demand under control. Different interest rates move for different reasons, so mortgage, credit-card, savings, and government-bond rates do not always change by exactly the same amount.
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What Is an Interest Rate?
An interest rate is essentially the price of borrowing money. A borrower pays interest to a lender in exchange for being able to use the lender’s money for a period of time.
Interest also works in the other direction. When you put money in an interest-paying savings account or buy certain bonds, you are effectively supplying money and can receive interest in return.
Rates are usually expressed as a percentage. The higher the rate, the more expensive borrowing generally becomes and the more attractive saving can become.
Why Do Interest Rates Go Up When the Fed Raises Rates?
In the United States, the Federal Reserve influences short-term interest rates through monetary policy. One important target is the federal funds rate, the rate banks charge one another for certain overnight loans.
When the Federal Reserve raises its target range, other short-term borrowing costs often move higher too. Banks and financial markets adjust to the new environment, which can eventually affect rates on credit cards, business loans, savings accounts, and other financial products.
The Fed does not simply set every interest rate you see. Mortgage rates, for example, are strongly influenced by longer-term bond markets and expectations about future inflation and economic conditions.
Why Do Interest Rates Go Up When Inflation Is High?
Inflation reduces what a dollar can buy in the future. A lender therefore has a reason to demand a higher interest rate when expected inflation rises, because the dollars repaid later may have less purchasing power.
Inflation can also lead the Federal Reserve to raise its policy rate. Higher borrowing costs tend to discourage some spending and investment, which can reduce demand in the economy and help relieve inflation pressure over time.
SmallQuestions explains the other side of this relationship in Why Does Inflation Happen?
How Does Borrowing Demand Affect Rates?
Interest rates are also influenced by supply and demand in credit markets. When many borrowers are competing for available funds, rates can rise. When there is plentiful money available to lend and borrowing demand is weaker, rates can fall.
This does not mean every loan responds immediately. Different markets have different lenders, borrowers, maturities, and rules. But the basic supply-and-demand relationship helps explain why market interest rates can change even without a new announcement from the Federal Reserve.
Why Does Risk Make Interest Rates Higher?
Lenders care about the chance that they will not be repaid. Greater perceived risk generally leads lenders to demand a higher rate as compensation.
That is why two people can apply for similar loans on the same day and receive different offers. Credit history, income, debt, collateral, loan length, and other factors can affect the rate a lender offers.
Risk also matters for companies and governments borrowing through bonds. Investors generally expect more compensation for lending to a borrower considered less likely to repay on time.
Why Don’t All Interest Rates Move Together?
There is no single interest rate for the whole economy. A 30-year mortgage, a credit card, a three-month Treasury bill, and a savings account are different financial products.
Short-term rates tend to respond more directly to Federal Reserve policy. Longer-term rates depend heavily on what investors expect inflation, economic growth, and short-term rates to look like years into the future.
Competition also matters. Banks can offer different deposit or loan rates depending on how strongly they want new customers or funds.
What Happens When Interest Rates Go Up?
Higher rates make many forms of borrowing more expensive. Monthly payments on new variable-rate debt can rise, and buyers may qualify for smaller loans because the same payment supports less borrowing at a higher rate.
Businesses may delay projects that are no longer profitable at higher financing costs. Consumers may postpone large purchases. Those effects are part of why central banks can use higher policy rates to cool unusually strong demand.
Savers can benefit in another way: banks and money-market products may offer higher yields when market rates rise, although deposit rates do not necessarily rise as quickly as borrowing rates.
Why Can Mortgage Rates Rise Before the Fed Acts?
Financial markets try to anticipate the future. If investors expect higher inflation or believe the Federal Reserve will raise short-term rates later, longer-term bond yields can move before an official policy decision occurs.
Mortgage rates are closely connected to longer-term financial markets, so they can rise or fall based on changing expectations. This is one reason the statement “the Fed raised mortgage rates” is an oversimplification.
Do Higher Interest Rates Make Prices Fall?
Not necessarily. Higher rates are intended to slow demand, which can reduce the pace at which prices rise. Inflation can fall while the overall price level remains higher than it was before.
For example, if inflation slows from 6 percent to 3 percent, prices are still increasing on average; they are simply increasing more slowly.
Frequently Asked Questions
Why do interest rates go up in simple terms?
Interest rates can rise because inflation is higher, borrowing demand is stronger, lenders perceive more risk, or the Federal Reserve has tightened monetary policy. Several of these forces can operate at once.
Who decides interest rates?
No single person or institution decides every interest rate. The Federal Reserve influences short-term rates, while banks, borrowers, investors, inflation expectations, risk, and financial markets help determine the many rates used throughout the economy.
Why do savings rates go up when interest rates rise?
Banks may pay more for deposits when market rates are higher because deposits are a source of funding. Competition among banks also affects how much of a rate increase reaches savers.
Why do credit-card rates rise?
Many credit cards have variable rates tied to a benchmark such as the prime rate. When benchmark rates rise, the annual percentage rate on variable-rate cards can rise as well.
Can interest rates go up even if the Fed does nothing?
Yes. Market rates can move because investors change their expectations about inflation, economic growth, future Fed policy, borrowing demand, or risk.
The Short Answer
Why do interest rates go up? Rates rise when the price of borrowing money increases. Common reasons include Federal Reserve policy, inflation and inflation expectations, strong demand for credit, and greater lending risk. The exact cause depends on which interest rate you are looking at.
Sources
- Federal Reserve Board — What Is the Federal Funds Rate?
- Federal Reserve Board — Federal Open Market Committee
- Consumer Financial Protection Bureau — What Is an Interest Rate?
- Federal Reserve Bank of St. Louis — Interest Rates and Inflation
Related questions: Interest rates connect closely with why inflation happens and why banks pay interest.