Higher interest rates usually reduce buying power for borrowers and increase income from savings. Lower interest rates generally do the opposite. For households, the effect usually shows up through two financial channels: the cost of borrowing and the return on savings. Inflation determines how much each dollar can buy.
Interest Rates and Buying Power at a Glance
| Interest-rate change | Borrowers | Savers | Overall effect |
|---|---|---|---|
| Rates rise | Loans become more expensive and monthly payments increase | Savings accounts, CDs and some bonds may provide higher returns | Spending usually slows, which can reduce inflation pressure |
| Rates fall | Loans become cheaper and borrowing power increases | Returns on cash savings may decrease | Spending and demand for assets may increase |
| Inflation remains high | Loan costs may rise as lenders price in higher inflation | Savings may lose real value if returns do not keep pace | Each dollar buys fewer goods and services |
What Buying Power Means
Buying power is the amount of goods and services a person can purchase with a given amount of money.
For households, buying power depends on:
- Income
- Prices
- Loan payments
- Savings returns
- Taxes and other fixed expenses
- Inflation
The Consumer Price Index, or CPI, measures changes in consumer prices. It can help estimate how the purchasing power of the dollar changes over time. When prices rise, the same dollar buys less.
How Higher Interest Rates Reduce Borrowing Power
Higher interest rates reduce borrowing power by increasing loan costs and monthly payments. A larger share of household income then goes toward interest, leaving less money for housing, transportation, food, travel and other purchases.
Higher rates can affect:
- Mortgages
- Auto loans
- Credit cards
- Personal loans
- Home-equity loans
- Business financing
- Variable-rate student loans
The Federal Reserve says changes in the federal funds rate influence other interest rates and financial conditions. Those changes affect household decisions about borrowing and spending.
Example: How Mortgage Rates Change Buying Power
Consider a $400,000, 30-year fixed-rate mortgage. These figures include principal and interest only. They exclude property taxes, homeowners insurance, mortgage insurance, closing costs and other fees.
| Interest rate | Monthly principal and interest | Total interest over 30 years |
|---|---|---|
| 4% | About $1,910 | About $287,478 |
| 6% | About $2,398 | About $463,353 |
| 8% | About $2,935 | About $656,621 |
At 8%, the monthly payment is about $1,025 higher than at 4%. That payment leaves less income available for other expenses.
A higher rate can also reduce the home price a buyer qualifies for because lenders consider whether the borrower can afford the monthly payment. The Consumer Financial Protection Bureau identifies the interest rate as one of the main factors in estimating an affordable home price.
The interest rate is only one mortgage cost. Borrowers should also compare points, mortgage insurance, lender fees, closing costs, property taxes and homeowners insurance.
How Lower Interest Rates Increase Borrowing Power
Lower interest rates increase borrowing power because they reduce the cost of financing. A borrower may then be able to:
- Qualify for a larger mortgage
- Buy a more expensive car
- Refinance existing debt
- Reduce monthly loan payments
- Use more income for everyday spending
- Invest in a business or property at a lower financing cost
The Federal Reserve states that lower rates can encourage households to borrow for homes, vehicles and other large purchases. Lower mortgage rates can also make homeownership more affordable and encourage refinancing.
Lower rates do not guarantee that an asset becomes cheaper. For example, lower mortgage rates can increase demand for homes, which may contribute to higher home prices. The lower financing cost may then be partly offset by stronger competition among buyers.
How Interest Rates Affect Savers' Buying Power
Higher interest rates can increase income from savings accounts, certificates of deposit, money market accounts and some bonds. That additional income can improve buying power for people who hold cash or receive interest income.
The gain depends on the relationship between the interest rate and inflation.
For example:
- Savings return: 5%
- Inflation rate: 3%
- Approximate real return: 1.94% before taxes
The real return measures the change in purchasing power after inflation. The calculation is:
[ \text{Real return} = \frac{1+\text{nominal return}}{1+\text{inflation rate}} - 1 ]
A 5% savings rate does not increase buying power by 5% if prices rise by 3%. Taxes can reduce the after-tax real return further.
The Federal Reserve describes real interest rates as interest rates adjusted for inflation. It also notes that stable, low inflation helps households make more reliable decisions about borrowing, saving and investing.
Why Higher Rates Can Eventually Improve Purchasing Power
Higher rates can support purchasing power over time if they slow inflation, even though they reduce a borrower's budget in the short term.
Higher rates often reduce borrowing and spending across the economy. When demand slows, businesses may face less pressure to raise prices. This is one reason central banks use higher rates to control inflation.
The process takes time. Monetary policy affects borrowing costs, spending, employment and prices over time rather than all at once.
The two effects can look like this:
- Short term: Higher rates usually reduce the spending power of borrowers.
- Over time: Slower demand may help reduce inflation, allowing each dollar to buy more than it otherwise would.
A higher rate can therefore strain a borrower's monthly budget while supporting the purchasing power of money later, if it successfully reduces inflation.
Fixed-Rate and Variable-Rate Debt Respond Differently
The effect of a rate change depends on the type of debt.
Fixed-Rate Loans
A fixed-rate mortgage or loan normally keeps the same interest rate and scheduled payment for the life of the loan. A later increase in market rates does not usually change the borrower's existing payment.
Higher rates still affect:
- New borrowers
- People refinancing
- Buyers who need a larger loan
- Borrowers with loans that are about to reset
Variable-Rate Loans
Adjustable-rate mortgages, home-equity lines of credit and some other loans can become more expensive when market rates rise. An adjustable-rate mortgage generally uses an index plus the lender's margin, subject to loan caps.
The Consumer Financial Protection Bureau warns that an adjustable-rate mortgage may start with a lower payment but increase substantially after the introductory period ends.
Who Benefits When Interest Rates Rise?
People with substantial savings, fixed-rate debt or enough cash to avoid borrowing may benefit when interest rates rise. People with new or variable-rate debt may be worse off.
People who may benefit include:
- Households with substantial savings
- Investors buying newly issued bonds
- Retirees earning interest income
- Buyers who can pay cash and avoid borrowing
- Consumers whose primary financial concern is inflation
People who may be disadvantaged include:
- New homebuyers
- Households carrying credit-card balances
- Borrowers with variable-rate debt
- Businesses that rely on financing
- Consumers with limited emergency savings
A household with a large mortgage and little cash savings may lose buying power when rates rise. A debt-free household with substantial savings may gain income from higher deposit rates.
How to Protect Your Buying Power
To protect buying power, compare the full effect of a rate change on your budget instead of looking at the advertised rate alone.
- Calculate the complete monthly payment. Include principal, interest, taxes, insurance, mortgage insurance, fees and maintenance where relevant.
- Compare APRs and loan estimates. The interest rate is only one part of the borrowing cost.
- Stress-test variable-rate debt. Estimate whether you could afford a higher payment after the introductory rate expires.
- Compare your savings return with inflation. A positive nominal return may still produce a negative real return.
- Avoid borrowing at the maximum approval amount. Lender approval does not guarantee that the payment is comfortable for your household.
- Consider the loan term. Shorter terms generally require higher monthly payments but reduce the amount of interest paid over time.
Bottom Line
A rate is not good or bad in isolation. The useful test is what remains after loan payments, savings income, taxes and inflation.
Compare those numbers before taking on debt, refinancing, or changing where you keep cash.