How Interest Rates Work

In March 2022, the U.S. Federal Reserve began raising interest rates at the fastest pace in 40 years — lifting the federal funds rate by 4.5 percentage points in roughly 12 months, the steepest climb since the early 1980s under Fed Chair Paul Volcker, according to the Federal Reserve Bank of Richmond. Within months, mortgage rates had doubled. Tech company valuations collapsed. Banks that had bought long-term bonds at low rates suddenly held assets worth much less. Silicon Valley Bank failed, partly because of this — its management had loaded up on long-duration Treasury bonds at low rates, and when rates surged those bonds lost significant market value. All of it traced back to a single number, set in a meeting room in Washington, D.C. Understanding interest rates means understanding why that one number has so much power over everything else.

The short answer

An interest rate is the percentage charged or paid for the use of money over time. Borrowers pay it. Lenders earn it. The rate reflects the cost of waiting (a dollar today is worth more than a dollar next year), the risk that the borrower won’t repay, and overall supply and demand for credit in the economy.

Central banks, like the Federal Reserve in the US or the European Central Bank, set a key benchmark rate that influences all other rates in the economy. When this rate goes up, borrowing gets more expensive everywhere, which tends to slow down spending and reduce inflation. When it goes down, borrowing gets cheaper, spending picks up, and the economy accelerates.

The full picture

Why interest exists at all

Lending money involves three distinct costs, and interest is compensation for all three.

First: time preference. People generally prefer having money now rather than later. If you give someone $1,000 today and they promise to give it back in a year, you’ve gone without that money for a year. Interest compensates for that sacrifice.

Second: inflation risk. If prices rise 3% over the year, the $1,000 you get back buys less than the $1,000 you lent out. Lenders charge interest partly to protect against this erosion.

Third: default risk. Some borrowers don’t repay. Lenders charge higher rates to borrowers who are more likely to default, which is why credit card interest rates are much higher than mortgage rates. A mortgage is backed by a physical house the lender can repossess. Credit card debt is backed by nothing but your promise.

The central bank rate: the anchor of the system

Every modern economy has a central bank that sets a short-term interest rate. In the US, this is called the federal funds rate, which is the rate at which banks lend money to each other overnight.

Banks need to hold a certain amount of reserves. On any given day, some banks have more reserves than required and some have less. Banks with excess reserves lend to banks with shortfalls, and the rate they charge each other is the federal funds rate. The Fed sets a target for this rate and uses tools to keep the actual rate close to the target.

This rate matters because it percolates through the entire financial system. Banks set their prime rate (the rate they offer their best customers) a few percentage points above the federal funds rate. Mortgage rates, auto loan rates, and credit card rates are all benchmarked against these foundational rates.

How rate changes affect the economy

The central bank raises rates to cool down the economy and lower rates to stimulate it. Here’s how the transmission works:

Higher rates slow spending. When mortgages get more expensive, fewer people buy houses. When business loans cost more, companies borrow less and invest less. Consumers with variable-rate debt (like credit cards or adjustable mortgages) have less money to spend each month because more goes to interest payments.

Higher rates strengthen the currency. Higher rates attract foreign investors who want to earn those better returns. To invest in US assets, they need to buy dollars, which increases demand for the dollar and strengthens its exchange rate.

Lower rates encourage risk-taking. When safe assets like savings accounts or government bonds yield almost nothing, investors move money into stocks, real estate, and other higher-risk assets in search of better returns. This inflates asset prices.

Lower rates make borrowing cheap. Businesses invest in expansion, hire workers, and launch new projects when the cost of capital is low. Consumers buy houses and cars.

Real vs. nominal rates

The rate you see advertised is the nominal rate. What actually matters is the real rate: the nominal rate minus inflation.

If your savings account pays 4% but inflation is 5%, your real return is negative 1%. Your balance grows in nominal terms, but each dollar buys less than before. You’re actually losing purchasing power.

This distinction is crucial for understanding central bank policy. When inflation spiked after 2021 and central banks raised nominal rates aggressively, the real rate still lagged behind inflation for a while, meaning borrowing conditions were still relatively easy even as nominal rates rose.

The yield curve: rates across time

Interest rates aren’t just one number. They vary by how long you’re lending money for. The yield curve plots interest rates against loan duration, from overnight to 30 years.

Normally, the yield curve slopes upward: longer loans command higher rates because lenders want more compensation for locking up money for longer. But sometimes the curve inverts, meaning short-term rates are higher than long-term rates. This happens when investors expect rates to fall in the future (perhaps because they expect a recession). As the Federal Reserve Bank of Cleveland notes, inverted yield curves have preceded each of the last eight U.S. recessions — a pattern documented across multiple Federal Reserve studies — which is why economists watch them closely.

How interest rates affect stock prices: the discount rate

The connection between interest rates and stock valuations is direct, and understanding it explains some of the market swings that seem puzzling from the outside.

Every stock is, theoretically, worth the present value of all its future cash flows. “Present value” means what a future dollar is worth today, and this calculation requires a discount rate, the rate at which you convert future money to present value. Higher discount rates mean future money is worth less today; lower rates mean future money is worth more today.

The risk-free interest rate, essentially what you’d earn from US Treasury bonds, sets the baseline for every other discount rate. When the Fed raises rates, Treasury yields rise. This has two effects:

First, it directly reduces the present value of future earnings. If a tech company’s profits are mostly expected in 10-15 years, rising interest rates significantly shrink what those future profits are worth today. Growth stocks, companies valued heavily on future earnings, get hit harder than value stocks that generate cash now.

Second, it makes Treasuries more attractive relative to stocks. If risk-free bonds pay 5%, investors demand higher returns from risky assets like stocks. This means stocks need to fall in price (raising their yield) to remain competitive. This is why “rates up = stocks down” became a reliable pattern in 2022.

The relationship also explains why markets care so intensely about Federal Reserve meeting decisions and the language used in press conferences. A surprise quarter-point rate change, which translates to a few hundred dollars on a typical mortgage, can move the stock market by several percent in minutes. It immediately reprices the discount rate applied to trillions of dollars in future earnings.

Why it matters

Interest rates touch almost every financial decision you make. The rate you pay on your mortgage. The return on your savings. How much your pension fund grows. Whether it makes sense to refinance your debt.

At a macro level, central bank rate decisions are among the most consequential economic policies a government makes. Too high for too long, and the economy contracts, businesses fail, and unemployment rises. Too low for too long, and asset bubbles inflate, inflation erodes savings, and financial stability is threatened.

The challenge is that no one knows the “right” rate with certainty. Central banks set rates based on imperfect data with a significant time lag: the Federal Reserve’s own analysis acknowledges that the full effects of a rate change can take a year or more to show up in inflation or employment statistics. It’s steering a ship by watching where you’ve been rather than where you’re going.

Common misconceptions

“When the Fed cuts interest rates, your mortgage rate automatically drops.” This only applies to adjustable-rate mortgages. If you have a fixed-rate mortgage, your rate stays the same until you refinance. Fixed rates are influenced by the Fed, but not directly set by it.

“Low interest rates are always good for the economy.” Low rates can inflate asset prices like stocks and real estate, creating wealth for owners but widening inequality. They also punish savers and can encourage excessive risk-taking that leads to financial instability.

“The Federal Reserve sets interest rates on all loans.” The Fed sets the federal funds rate, which influences short-term rates. Mortgage rates, auto loans, and corporate borrowing rates are market-driven and depend on factors like credit risk, inflation expectations, and the yield curve, not just Fed policy.