How U.S. Interest Rates Impact Your Money

Money Morning Capital Wave Strategist Shah Gilani expects U.S. interest rates will be raised in December, but many investors still don't know how interest rates impact their money.

From bonds to gold, interest rate hikes affect the entire economy. Rate hikes even affect the price of your groceries.

That's why we're showing investors exactly how interest rates work, as well as the widespread impact they have on your money.

Because interest rates can impact a lot more than you think...

Understanding U.S. Interest Rates

Interest rates provide lenders an incentive to lend out money.

Any lender has the risk of a borrower defaulting. So to bear that risk, interest rates provide the borrower a certain level of compensation and protection. The reward from lending money should outweigh the possibilities that borrowers default.

For example, say 100 borrowers take out a 10-year loan of $10,000 with an interest rate of 5%. In 10 years, the lender would have made $500,000 in interest rate payments if every borrower pays back their loan on time.

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The profit potential is so high that even if one borrower never makes any payments on the $10,000 loan, the lender still makes $495,000 from the 99 other borrowers who paid on time in full.

U.S. interest rates also protect lenders against inflation. As the costs of goods and services increase, money lent earlier in time loses its spending power as time passes. The money received from interest rate payments offsets that risk.

So what does this have to do with the Federal Reserve? Here's your answer...

The Fed oversees interest rates to promote a healthy economy. And the process is a balancing act for Fed officials.

You see, if interest rates are too high, people aren't able to borrow money. That means fewer people in the United States will spend money on homes, cars, or starting a business.

But low or near-zero interest rate levels can also have negative consequences.

For instance, low interest rates mean there is less incentive for people to keep their money in banks. That's because they are earning less on their deposited money, so they keep their money elsewhere. And with less money coming into banks, these banks have less money to loan.

Right now, we are in a low-interest-rate environment. The Fed is keeping rates between 0.25% and 0.5%. But that has banks in the United States struggling. JPMorgan & Chase Co. (NYSE: JPM) is up 2% in 2016, Bank of America Corp. (NYSE: BAC) is down 7.3%, and Wells Fargo & Co. (NYSE: WFC) is down nearly 16%. In the same time, the Dow is up more than 5%.

But earning more money from your bank deposits is just one way interest rates impact your money. There are also numerous other ways your money is affected when U.S. interest rates are raised.

Here are the specific areas where U.S. interest rate hikes will affect your money...

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U.S. Interest Rates Impact No. 1: A Stronger U.S. Dollar

The dollar becomes stronger when interest rates are high because of supply and demand. Less people can afford to pay back higher interest rates, making money scarce. Importing goods from other countries then becomes cheaper. The savings from importing goods can be passed on to customers, theoretically increasing business sales by customers spending more money.

One way investors can benefit from a stronger dollar is to invest in good companies who earn the bulk of their money in America.

For example, Germany's stock market climbed 8.3% in the first 10 months of 2015, according to Time magazine.

But if you converted those gains back into U.S. dollars, though, investors would have lost 1.1% through the exchange rate.

And there can also be negative consequences from a stronger U.S. dollar.

Companies that export goods could see a decrease in revenue. When the dollar is strong, it costs other countries more money to import our goods. That makes them less likely to do so.

According to a Duke University/CFO Magazine Global Business Outlook survey in 2015, two out of three big U.S. exporters (those with one-fourth of their total sales overseas) said a stronger U.S. dollar would have a negative impact on their businesses.

Nearly one-fourth of big exporters also said they would have to reduce their capital spending plans because of the stronger dollar. And 8.6% of those surveyed said a stronger dollar would create a negative effect for their hiring plans.

So the stronger U.S. dollar can lead to weaker returns for stocks who rely on exporting, as well as slow down hiring.

U.S. Interest Rates Impact No. 2: Stronger and Weaker Bond Returns

Government/agency bonds are typically viewed as a "safe haven" because they are guaranteed by the U.S. government. But when interest rates are so low (like they are now), bonds become less attractive investments.

The bond yield is already low compared to the stock market. For example, the return on Series I Bonds from May 1 to Oct. 31 is just 0.26%.

In comparison, the Dow Jones Industrial Average is up 5.62% so far in 2016.

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When U.S. interest rates are raised, though, the certainty of repayment and higher yields makes the bond market an appealing investment vehicle.

But the bond market is tricky because you have to play a guessing game with the Fed's interest rate policy. Every time the Fed raises rates, older bonds will pay out less compared to the new interest rate yields.

But investors shouldn't view this as though they are losing money if they own older bonds. They are still earning money with old bonds, just not as much as the new bonds offer.

For example, a 30-year bond paying 1% interest would be worth $1,348.85 when it matured. A bond interest yield paying 2% would be worth $1,816.70 when it matured.

That's a profit increase of over 34% when interest rates are raised by just 1%.

U.S. interest rates can also affect the value of precious metals...

U.S. Interest Rates Impact No. 3: Gold and Silver Prices Slide

So far in 2016, gold and silver have brought investors market-beating profits.

At the start of 2016, gold was trading for $1,063.22 an ounce, and silver was trading for $13.90 an ounce. Today gold is up 24.7% for the year, and silver is up 41%.

But climbing interest rates have a bearish impact on gold and silver prices.

The first reason is because gold and silver don't provide dividends or interest rates. When interest rates are raised, savings accounts and bonds are able to offer appealing yields.

Instead of buying gold and getting nothing, investors would rather have their money earn them interest. So gold and silver demand drops.

The second reason precious metal prices fall after U.S. interest rates are raised is because of a stronger dollar.

Since gold and silver are priced in dollars, it costs foreign nations more money to purchase gold when the dollar is stronger. And because supply and demand drives the price of precious metals, the price falls because foreign investors are less likely to buy gold at higher prices.

Even though gold prices are volatile, Money Morning Resource Specialist Peter Krauth is still extremely bullish on the price of gold for 2016. In fact, he sees it climbing 277% by 2020.

Find out more about Krauth's prediction and the reasons gold will climb, right here.

And while those are the three biggest areas investors focus on when talking about interest rates, these rates impact your wallet in a number of other ways...

Additional Ways U.S. Interest Rates Affect Your Money

• Auto Loans: Because of the stock market crash of 2008, auto companies have relied on loans with low rates to attract customers. In February 2009, light vehicle sales were at 9 million. By November 2015, those sales climbed to 18 million. Car loans can average between 2% to 3% now, but car loans were 8% before the crisis, according to CNBC.
• Mortgage Rates: An interest rate hike won't affect you if you have a fixed mortgage. You are locked in at one rate, no matter what the Fed does. But if you have a mortgage with adjustable rates, you will start to see higher bills monthly or annually. Buying a house before Fed meetings can help you potentially lock in a lower interest rate before the end of 2016.
• Credit Cards: Most credit cards have variable interest rates, which means your payments will go up quickly if the Fed raises interest rates. And if the interest rate increases, your minimum payment will also increase. According to Forbes, most major credit companies will take a percentage of your principal and add the interest accrued during that period to create a new minimum payment.
• Travel Industry: A Fed rate hike can mean cheaper travel expenses for Americans visiting foreign countries because the dollar is stronger. European central banks' and the Bank of Japan's easing programs for their national currency also helps you buy more for less.

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