(Image source: WSJ)
One of the reasons that finance scares off a lot of well-meaning people is that it’s full of conflicting messages. Take interest rates, for example. In some cases, you want a really high interest rate. In other cases, you want to get the lowest rate possible. And when it comes to “sovereign debt,” reporters at Bloomberg and the Wall Street Journal work themselves into a real panic when interest rates are rising too quickly. Here’s how it works: An interest rate is essentially the cost of borrowing money.
- When you take out a loan, you pay a certain amount of interest for the privilege of borrowing. If the bank is pretty sure you’ll pay back what you owe, your interest rate will be lower. If you have horrible credit and the bank sees you as a risky borrower, your interest rate will be higher.
- If you fail to pay off your credit card balance in full, you’ll have to pay a lot of interest in exchange for the company basically lending you money you don’t have.
- When governments want to raise money by selling bonds - which are really just IOUs with more rules and regulations attached - it offers to pay a fixed amount of interest to anyone purchasing a bond.
On the flip side, sometimes banks and other institutions will pay you for the privilege of holding on to your money. If you deposit $1,000 into an interest-bearing savings account at your bank, it doesn’t just sit there. Your bank will “borrow” that money from you to use as it pleases. (It usually pleases banks to use your money to make more money for themselves.) But in return, it will pay you a small amount of interest on your deposit. In this case, you want to get the highest interest rate possible.
When you want interest rates to stay low:
- If you’re the one borrowing money, you obviously want to pay as little interest as possible. (Pay those credit card bills on time, kids.)
- If you’re a government, you also want to pay as little interest as possible on the bonds you’re selling. But that isn’t so easy…
- If your economy is stable and running smoothly, more investors will want to buy your bonds. That’s because there’s less risk of losing their money. In exchange, you (the government) can pay a relatively small amount of interest to these investors. But if things start to get out of control - as they are in Greece and Italy right now - your bonds become a riskier investment. After all, the more unstable things are, the more likely you are to default on your debts. In exchange for this increased risk, a smaller pool of investors will demand a much higher interest rate.
So there you have it. High interest rates on government bonds (“sovereign debt”) indicate economic instability, and that’s bad. High interest rates on your credit card balance indicate that you’re not using credit responsibly, and that’s bad, too. And high interest rates on your savings and investment accounts? That’s good. Very good. Way to go.