Understanding Interest Rates Is Crucial In This Day And Age
Interest rates are fundamental to every financial transaction we make, and are particularly important to consider when one is saving money. Becoming acquainted with the basics of understanding interest rates should begin with knowing what the prime interest rate is, and how it affects loan rates. Beyond this, gaining a better grasp of how the 1099 you receive from your bank at the end of the year, and that which you have to submit with your annual tax return as earnings, has a very deleterious effect on the stated interest rate on that account. If you are in the 35% tax bracket, and you are earning 2% on a savings account, you are in all actuality earning roughly 1.3% interest on that savings account after taxes. Interest rates should also always be considered when investing, like in municipal bonds for example. One would want to be at least aware of what way the Federal Reserve might be moving on federal reserve rate, and also having some understanding of how that rate will affect the yield curve is important. Once you have a better understanding of some of the basics, you can then use an interest rate calculator, which are available online, to determine how these moves will effect transactions you are planning to make.
What Is Prime Anyway?
The prime rate is the rate a bank charges its most creditworthy customers on loans, and it is based on the federal funds rate as set by the Federal Reserve Bank. An applicant with less-than-perfect credit is guaranteed to pay higher than prime, and their rates will go up as the credit risk the financial institution has to assume to loan funds rises. This is why it is very important to plan for opportune times to take loans. During slack periods in the economy where money is not tight, some customers of banks with excellent credit may actually be extended rates below prime. That being said, the average customer can expect to pay at least 1 to 2 points above prime. This is how calculating interest rates should figure into everyone’s budget before borrowing funds.
International competition is also another factor in why a bank might charge less than prime. The US dollar is considered the world’s international currency, and with the current trade deficits this country has run up in the past 10 years, there are trillions of American dollars floating in the world’s money markets. London, which is the center for Eurodollar deposits, is also where the preponderance of US dollars can be found in the international money markets. Companies based in the United States can borrow dollars from London banks very easily, so under the auspices of being fiscally prudent, they naturally shop for the best rates.
This is why U.S. banks have to compete with the international money markets, offering competitive rates, even below prime, at times. This international nature of our floating dollars largely ending up in London is also why the prime rate competes directly with the London Interbank Offered Rate (LIBOR). It is not much of a competition, however, as the LIBOR has consistently been below the U.S. prime rate since 1997, and at times that spread has been over 2 basis points. That is a lot of money for a multinational firm that is loan shopping to leave on the table, so domestically situated banks will go below prime to attract business of those with excellent credit, and so as to compete with the LIBOR. Of course, the LIBOR rates came under fire with a price-fixing scandal in 2012 where British regulators uncovered that the LIBOR was being manipulated. The United States suspected this activity was taking place as early as 2007, but British regulators did not act on it at that time, and many speculate it was because they could not figure out how it was happening. The perpetrators of financial crimes are often times far more knowledgeable than regulators.
The Average Borrower
People may tune into the evening news and hear these terms tossed about, but not ever really comprehend how these interest rates today affect them. Knowing what is going on is not a call to arms, but it is to help people try to take better advantage of gyrations in the financial markets. If every person in the United States knew that the Federal Reserve was going to increase interest rates in January 2016, they would want make all debt-related moves now so as to lock-in lower rates. To this point they would want to buy their new cars now, get the line of credit locked-in on their homes now, take out personal loans if needed, and perhaps even refinance their homes if it makes sense.
Most everyone is a debtor as well as a financier, but they likely don’t realize that. Most people perceive themselves as chronically in debt, and while this may be true, if you have a 401K with a bond fund in it, you are indirectly making a loan to either a municipality, or a corporation. If you own any municipal bonds, CD’s or corporate bonds, you are a financier. If you have an IRA at your local bank, you are a financier. To this point, if you know that the Federal Reserve is going up on the prime rate in January of 2016, you do not want to buy a CD at your local bank now. What you want to do is wait until January when you will be able to make more money on the funds you are loaning, either in the form of a CD, a municipal bond, a corporate bond or even how you allocate investments in your 401K. To this point, all that talk on the news about Janet Yellen, the Federal Reserve and the federal funds rate, which is what the prime rate is based on, effects every single person in our country. It is just hard to peel back the layers to get a better understanding as to exactly what it all means for each individual.
Understanding Interest and Investments
An IRA should always contain investments that would incur a taxable event at the end of the year, if it were not in an IRA. This is a particularly tricky facet of saving for retirement for people to understand. That being said, one would never want municipal bonds in their IRA as it is both redundant, and fiscally ineffectual. Any tax-free investments, like municipal bonds and treasury bills, will be best held in a traditional brokerage account. There is absolutely no reason to monopolize your annual IRA contribution by placing those dollars in tax-free investment. It is a huge waste of an opportunity, and if you listen really closely, you can hear the vacuum sucking money out of your wallet!
Many bank-related financial representatives like to talk customers into putting fixed annuities in IRAs. There is perhaps only a few greater fiscal travesties. The rule-of-thumb would be to ask your investment professional if the results of an investment will cause you a taxable event at the end of the year. If the answer is yes, those investments should be made in your IRA until, of course, you have exhausted all liquid dollars and have maxed-out your annual contribution. All investments that do not carry a taxable event at the end of the year can be made in brokerage and bank accounts. Keep the IRA for buying investments where you would be incurring a taxable event at the the end of the year.
These are just basic tips on how interest rates affect every person in this country, and how to help yourself to managing your finances better by gathering just a basic understanding of how using an interest rate formula can help the average investor save thousands of dollars.