How Do Interest Rates Affect Debt?

Being in debt is one thing. You know how much you owe to a person, a company or a financial institution and you work on repaying that debt. But you probably already noticed that there is more to it than that. Because on top of just repaying your debt, some of the money you pay every billing cycle is used to serve interest as well. In basic terms, interest is the money the lender makes off of you, in return for giving you their money. Interest is how lending out money becomes profitable.

This is why interest is often referred to as the cost of borrowing money. Because without interest, borrowing money would just mean using your future money today. But because of interest, taking out debt not only gives you access to your future money today, it also means you have less money in total than you would have if you just waited for your future money to arrive on its own. Just that by taking out debt, you get a lot of it in one go.

Just like the prices for everything, though, interest rates are not fixed. Sure, there are lending arrangements that fix interest rates over a repayment period, but even these fixed interest rates can be negotiated first before they are agreed on. This is particularly relevant today, because interest rates seem to be lower than ever. Whether in mortgage refinancing, personal loans, or student loan refinancing, all of these areas seem to have seem massive drops in interest rates recently.

Why are interest rates low right now?

A major reason why interest is so low these days is the coronavirus pandemic. Most importantly, the crisis caused by the pandemic and the government’s weak response to it has prompted the Federal Reserve to cut its federal funds rate. The low federal funds rate ripples through the entire finance sector and makes lending money a lot cheaper for everyone who is considered creditworthy. This effect is made even stronger by the fact that the Federal Reserve has pledged itself to low interest rates until 2023.

Another reason for these low interest rates is inflation. Inflation has been below 2 percent for a long time now, which means that money has mostly retained its relative value over time. Inflation basically is the process by which money slowly loses its value, because over time there is more and more money around. And the more there is of something, the less it is worth. However, low inflation means that this process of devaluation has been relatively slow, allowing the rates of long-term loans, such as mortgages, to be driven down as well.

How can you take advantage of interest rates?

Only because interest rates are low now does not mean that you can take advantage of it. After all, you may have taken out your student loans or mortgage years ago when interest rates were still higher, and your rates are fixed to that level. This means that the interest you are paying on your loans will stay the same, independent of what interest rates are right now.

Luckily, there is one way in which you can take advantage of today’s lower interest rates: Refinancing. Especially in the mortgage sector, low interest rates have led to a lot of people seeking refinancing on their loans. Now, not everyone is eligible for refinancing. It will depend on quite a few factors, including whether or not you have refinanced before and what your current situation is. If you are eligible for refinancing, though, even pushing down your interest rate by one percent can end up saving you thousands of dollars on your loan.

For example, changing your interest rate from 4.5% to 3.5% on a 30-year, $250,000 mortgage would change your total interest payments from $206,017 to $154,140. Those are more than $50,000 saved, only thanks to that one percent drop in your interest rate. The lower your loan, the less significant small percentage changes will be. But even on student loan debt worth a few ten thousand dollars, getting a lower interest rate will make a difference.

So, one way to take advantage of low interest rates is to look into refinancing options. It is definitely worth it to explore some opportunities there. Another way to take advantage of low interest rates is to consolidate your credit card debt with a personal loan. Because personal loans may also allow you to benefit from how low interest rates are right now.

The bottom line.

This is how interest rates affect debt. Take advantage of low interest rates by looking into refinancing or debt consolidation options. Just keep in mind that there are a few factors that will be crucial for your success, such as your credit score, employment history and current income and debts. The type of loan you are going for will also make a difference here. Make sure to look into your options, though, because you never know when interest rates will be as low as this again.

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