What is Interest Rate? (Plain English Definition)
Definition: An interest rate is the cost of borrowing money or the return earned on lending money, expressed as a percentage of the principal amount.
Interest Rate Explained Simply
An interest rate is the price of borrowing money. When you take out a loan, you pay interest. When you buy a bond or deposit money in a savings account, you earn interest. Interest rates are set by supply and demand for money, but the Federal Reserve heavily influences them through its federal funds rate.
The Federal Reserve raises interest rates to combat inflation and lowers them to stimulate economic growth. These rate changes ripple through the entire economy, affecting mortgage rates, car loan rates, savings account yields, and importantly, bond and stock prices. When rates rise, bond prices fall because new bonds offer higher yields, making existing lower-yielding bonds less attractive. Stocks can also decline because higher rates increase borrowing costs for companies and make bonds a more competitive alternative to stocks.
Interest rates have a profound impact on ETF performance. Bond ETFs with longer duration are most sensitive to rate changes. Stock ETFs in rate-sensitive sectors like real estate, utilities, and financials can be significantly affected. Even broad market ETFs react to interest rate expectations, as rate changes influence corporate profits, consumer spending, and economic growth.
Interest Rate Example
When the Federal Reserve raised rates from near 0% to over 5% in 2022-2023, the impact was dramatic. The iShares 20+ Year Treasury Bond ETF (TLT) fell over 40% as long-term bond prices plummeted. Meanwhile, money market ETFs went from yielding near 0% to over 5%. An S&P 500 ETF dropped about 19% in 2022 partly due to higher rates, but recovered as markets adjusted to the new rate environment.
Why Interest Rate Matters for ETF Investors
Interest rates are arguably the most important macroeconomic variable for ETF investors. Rate changes affect virtually every investment in your portfolio. Bond ETFs are directly impacted through price changes. Stock ETFs are affected through changes in corporate borrowing costs and investor preferences between stocks and bonds. For ETF investors, understanding the interest rate environment helps with asset allocation and fund selection. In rising rate environments, short-duration bond ETFs and floating-rate funds tend to outperform long-duration bonds. In falling rate environments, long-duration bond ETFs can deliver substantial gains. Being aware of the rate cycle helps you position your portfolio appropriately.
Interest Rate vs Inflation
| Interest Rate | Inflation |
|---|---|
| An interest rate is the cost of borrowing money or the return earned on lending money, expressed as a percentage of the principal amount. | See full definition of Inflation |
While interest rate and inflation are related concepts, they serve different purposes in the world of ETF investing. Understanding both terms helps you make more informed decisions about which funds to include in your portfolio and how to evaluate their performance.
Related Terms
Deepen your understanding of ETF investing by exploring these related concepts:
Inflation
Inflation is the rate at which the general level of prices for goods and services rises over time, reducing the purchasing power of money.
Bond
A bond is a fixed-income investment where you lend money to a government or corporation in exchange for regular interest payments and the return of principal at maturity.
Duration
Duration measures a bond or bond fund's sensitivity to interest rate changes, expressed in years -- the higher the duration, the more the price moves when rates change.
Treasury Bond
A Treasury bond is a debt security issued by the U.S. government with a maturity of more than 10 years, considered one of the safest investments in the world.
Yield Curve
The yield curve is a graph showing the interest rates on bonds of different maturities, typically U.S. Treasuries, from shortest to longest term.
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