Gaining an understanding of how interest rates impact your purchases and investments is key to making sound financial decisions.

very time Federal Reserve Board Chairman Alan Greenspan announces a change in interest rates, it makes a big splash in the news. If you think it's much ado about nothing, what you don't know may be hurting you: Understanding how interest rates work may help you make better financial decisions.

Interest Rates: The cost of money
Interest rates affect many aspects of your financial life. Each time you make a car or mortgage payment, you are affected by interest rates. When auto manufacturers offered zero percent financing in late 2001, new car sales increased dramatically. Lower interest rates can mean smaller monthly payments. You may also be able to borrow more without increasing your monthly payments. And, of course, when interest rates are low, the amount of interest you pay over the life of the loan is reduced.

Similarly, low interest rates are good news to families buying a home or refinancing an existing home loan.

It's easy to see why people love low rates. But every coin has a flip side. Low rates don't look so good when you consider the yield on your savings accounts, certificates of deposit, or money market investments.

How interest rates change
The Federal Reserve System (the Fed) is charged with conducting the nation's monetary policy and maintaining the stability of the financial system. Created by the federal government in 1913 to oversee the banking industry, the Fed is composed of a Board of Governors and 12 regional Federal Reserve banks. The chairperson of the Board of Governors is appointed by the President of the United States and traditionally chairs the Federal Open Market Committee (FOMC) as well. This committee meets eight times a year to decide how best to carry out its mission to promote maximum employment, stable prices, and moderate, long-term interest rates. To this end, the Fed has been given the authority to set the federal funds rate, which is the rate banks charge each other for overnight loans. It also sets the discount rate, which is the rate banks pay when they borrow from a Federal Reserve bank.

The Fed usually raises rates when the economy is growing quickly and inflation becomes a threat. To spur economic growth when the economy slows, the Fed may reduce rates to stimulate spending and ease the financing of business expansions.

When the Fed increases rates, your bank pays more for the money it borrows and passes the higher costs to you by charging higher rates for loans and credit card debt. Conversely, it also passes lower rates on to you by paying less interest on CDs, savings accounts, and money market accounts.

Interest rates and investing
We've all seen news stories about how the stock market responds quickly to interest rate changes, but investors should remember that bonds are also sensitive to interest rates. Bond prices move opposite interest rates, rising when rates fall and falling when rates rise.

So, when you begin thinking about making a large purchase, refinancing your home, or investing in bonds, pay attention to interest rates—what you know can make a difference!

The above article is for general information only and is not intended to provide specific advice or recommendations for any individual. Consult your attorney, accountant, or financial or tax advisor with regard to your individual situation. © Mutual of America Life Insurance Company August 2002. All rights reserved.

Mutual of America Life Insurance Company is a Registered Broker-Dealer.