How Interest Rates Affect Debt

Written by AJ Dellinger – 4 min read – Edited by Aylea Wilkins 

Borrowing money isn’t as simple as asking for how much you need and having the bank lend it to you. Borrowing money comes at a cost dictated by the current interest rate. Think of the interest rate as the price you pay your borrower. They provide you with a large sum of money upfront, and you pay it back in smaller installments and interest on that initial sum.

General interest rates are determined by the Federal Reserve and are typically influenced by economic conditions. Understanding the current interest rates is important because they affect the true cost you will pay for anything that requires a loan. Everything from the national debt to the cost of your credit card bill is affected by interest rates.

How interest rates affect debt nationally

The Federal Reserve sets the national interest rate, but the central banking system of the United States isn’t exactly your traditional federal agency. It is an independent, unique public/private entity that can be beholden to Congress but dictates interest rates and other conditions that affect the national economy on its own.

The Federal Reserve has to balance many conditions when determining the interest rate, including how it will affect the national debt. The national debt is currently at around $32 trillion, with the majority held by the public in the form of Treasury bills, notes, bonds, and other savings vehicles. The federal government is expected to pay interest on that debt, and the amount it must pay rises when the interest rate increases.

According to the Congressional Budget Office, current projections see debt as a percentage of gross domestic product expected to rise in 2024, partly because of the rising interest rate that increases the total amount of debt payments the federal government must make. At the current rate, debt as a percentage of GDP is expected to reach a historical high in 2031, when it could be as high as 107%. That could go higher if interest rates continue to climb or shrink if the rates are adjusted down.

How interest rates affect your individual debt

While the interest rate’s effect on the national debt may have some affect on you — particularly if you hold a Treasury bond — it is more likely that you’ll feel the impact of the interest rate on forms of individual debt.

Typically, the Federal Reserve raises interest rates to try to ease the amount of spending and combat inflation and lowers the rate to try to increase spending and kickstart a lagging economy. Higher interest rates encourage saving, while lower interest rates encourage spending.

Mortgage rates are particularly affected by fluctuating interest rates, as are other forms of personal debt like auto loans, personal loans, and credit cards.

“Since the Fed has raised interest rates a lot of things have changed. One of the main impacts has been the rise of interest rates on 30 year mortgages,” Deacon Hayes, financial advisor and founder of WellKeptWallet.com, explained. “When 30 year mortgage rates were around 3% about this time last year, it made the buying decision a lot easier. People could buy a bigger home and afford the payment. If someone would buy today, the size of the home they could afford would be much smaller.”

Similarly, Hayes said that people are less likely to want to sell their home than they previously would have been because of the low interest rates — especially if they locked into a lower fixed-rate mortgage and would rather hold onto that than enter into a higher mortgage rate on a new home.

Like mortgages, credit cards are affected by the Federal Reserve’s interest rates. According to Hayes, credit card interest rates are up nearly 2% over the past three months. “This means that people who carry a balance are going to be paying that much more in interest on the items they bought over time which will cut into the amount of money each month they have to spend and save,” he says.

How interest rates affect your credit score

Interest rates don’t have a direct affect on credit scores, meaning your score will not be affected by securing a card with a higher or lower interest rate. However, there is an indirect affect in the form of debt. Higher interest rates mean you’ll be paying more on any balance that you carry, which can lead to growing debt.

When interest rates rise, it can mean that your payments get bigger and your budget gets tighter. If you miss a payment or are unable to make it in full, you may end up hurting your credit score.

How you can get lower interest rates

While the Federal Reserve sets the baseline interest rates, financial institutions set their own rates based on the financial service they offer. Credit cards, for example, will always carry a higher average interest rate than mortgages because one is a short-term, unsecured loan and one is a long-term loan with collateral.

For this reason, it’s important to shop around and compare interest rates at the institutions you are considering getting a loan from. Compare the interest rates they are offering, and determine if it is best to lock into a fixed-rate or an adjustable rate in hopes of securing better terms down the line.

Hayes also recommends paying off all debt payments on time and not carrying over credit card payments when at all possible. “They should also keep their credit utilization under 30%,” Hayes said. “This shows the lender that you are a low risk because you are not out there maxing out credit cards. This will also make it easier to qualify for lower interest rates on credit cards, home loans, et cetera.”

Bottom line

The Federal Reserve sets the baseline interest rate, which can significantly impact both the national and individual debt, depending on what financial services you may need.

When interest rates are increased to slow spending and fighting inflation, mortgages become more expensive and credit card payments grow larger. When interest rates decline to spur more spending, mortgages become more affordable, but the market becomes more competitive. Keeping track of the interest rates can help you know what financial decisions to make.