Interest rates show up everywhere: in the yield on your savings account, the rate on your credit card, the payment on a mortgage, and the headlines about the Federal Reserve. They also explain one of the most confusing facts in investing: bonds, the "safe" investment, can lose value.

This guide connects those dots. It's step 5 of our Money & Investing learning path, and it ties together ideas from our stock market, debt and credit, retirement accounts, and rental property guides.

✅Key takeaways: (1) An interest rate is the price of borrowing money, and the reward for lending it. (2) The Federal Reserve sets a short-term target rate; markets set most other rates. (3) When rates rise, existing bond prices fall, and longer bonds fall more. (4) Rates affect savings yields, loan costs, stock values, and property values all at once. (5) Inflation matters: your real return is your rate minus inflation. (6) For most people, bonds belong in a diversified mix, often through low-cost bond funds or Treasuries.
⚠️Education, not advice: This guide explains how rates and bonds work in general and uses illustrative numbers, not forecasts. Nobody can reliably predict rate changes. For decisions about your own portfolio, consider a fee-only fiduciary adviser.

What is an interest rate?

An interest rate is the price of money. Borrowers pay it; lenders and savers earn it. It's usually quoted as an annual percentage:

Two related ideas:

Who sets interest rates?

The Federal Reserve

In the US, the Federal Reserve (the Fed) is the central bank. Its Federal Open Market Committee meets about eight times a year and sets a target range for the federal funds rate: the short-term rate banks charge each other for overnight loans.

The Fed raises rates to cool inflation and lowers them to support jobs and growth. Changes ripple out fast to:

Markets

Most longer-term rates, such as 10-year Treasury yields and 30-year mortgage rates, are set by markets. They reflect expectations about future Fed policy, inflation, economic growth, and risk. That's why mortgage rates can move even when the Fed doesn't, and why they don't always move when it does.

What is a bond?

A bond is a loan you make to a government or company. In return, the issuer typically:

  1. Pays you interest (the coupon) on a schedule, often twice a year.
  2. Repays the face value (often $1,000 per bond) on the maturity date.

Key terms:

Term Meaning
Face value (par) The amount repaid at maturity, often $1,000
Coupon rate The annual interest as a percentage of face value
Maturity When the bond is repaid
Yield The return you'd earn buying the bond at today's price and holding it to maturity
Credit rating An agency's assessment of the issuer's ability to repay, from AAA down. "Investment grade" means BBB−/Baa3 or higher; below that is "high yield" or "junk"

Why bond prices fall when rates rise

This is the key idea. Imagine you own a bond paying 4%. Then market rates rise, and new, similar bonds pay 5%. Nobody will pay full price for your 4% bond when they could buy a new one paying 5%. So your bond's price drops until its yield to a new buyer matches the market.

The reverse is also true: if rates fall to 3%, your 4% bond becomes more valuable.

Here's what happens to a $1,000 bond with a 4% coupon (simplified, annual payments):

Maturity Price if rates rise to 5% Price if rates fall to 3%
2 years about $981 about $1,019
10 years about $923 about $1,085
30 years about $846 about $1,196

Longer bonds swing more. That sensitivity is measured by duration, roughly: for every 1 percentage point change in rates, a bond's price moves by about its duration in percent, in the opposite direction. A bond fund with a duration of 6 years would lose roughly 6% if rates rose by 1 point.

If you hold an individual high-quality bond to maturity, you still get the full face value back regardless of what prices did in between. Price swings matter most if you need to sell early, or if you own a bond fund, which never "matures."

Types of bonds

Type Issued by Key features
Treasury bills, notes, and bonds US government Backed by the US government. Bills mature in a year or less; notes in 2 to 10 years; bonds in 20 or 30 years. Interest is exempt from state and local income tax
TIPS (Treasury Inflation-Protected Securities) US government Principal adjusts with inflation
Series I savings bonds US government Inflation-linked savings bonds bought through TreasuryDirect, with annual purchase limits; can't be cashed in during the first year, with a small interest penalty before five years
Municipal bonds States and cities Interest is often exempt from federal income tax, and sometimes state tax for residents
Corporate bonds Companies Higher yields than Treasuries for taking on more credit risk
Certificates of deposit (CDs) Banks and credit unions Not bonds, but similar: a fixed rate for a fixed term, insured up to coverage limits, with penalties for early withdrawal

The yield curve

The yield curve plots yields on Treasuries of different maturities. Normally, longer maturities pay more, because lenders want extra reward for tying up money longer. Sometimes short-term yields rise above long-term yields, an inverted yield curve, which has often (not always) come before recessions. It's a widely watched signal, not a reliable timer.

How rates ripple through your finances

Area When rates rise When rates fall Learn more
Savings and CDs Yields rise Yields fall Emergency fund guide
Credit cards and variable loans Costs rise quickly Costs ease Debt and credit guide
Mortgages New loans cost more; existing fixed-rate loans don't change Refinancing may become worthwhile Debt and credit guide
Existing bonds Prices fall Prices rise This guide
Stocks Future profits are worth less today, and borrowing costs more; often a headwind Often a tailwind Stock market guide
Rental property Higher mortgage costs shrink cash flow, and cap rates tend to rise, which can push prices down The reverse Rental property guide

In our rental property example, the same property lost about $123 a month at a 7% mortgage rate and broke even at 6%. That's interest rates at work.

How to own bonds

How much in bonds?

There's no single answer. Bonds typically:

People often hold more bonds as they get closer to needing the money, which is exactly what target-date funds do automatically. Your mix should reflect your time horizon and how you'd handle a large drop. If you'd sell in a panic during a 30% stock decline, more bonds may be worth the lower expected return.

Common mistakes

Frequently asked questions

Why do bond prices go down when interest rates go up?

Because new bonds pay the higher rate, so existing bonds paying less are only attractive at a lower price. The price falls until its yield matches the market.

Are bonds safe?

High-quality bonds, especially US Treasuries, have very low default risk, but their prices still move with interest rates. Longer bonds move more. Lower-rated bonds add credit risk.

What's the difference between a bond and a bond fund?

An individual bond repays its face value at maturity. A bond fund holds many bonds, constantly replaces maturing ones, and has no maturity date, so its price keeps moving with rates. Funds offer diversification and convenience.

Does the Fed set mortgage rates?

Not directly. The Fed sets a short-term target rate. Mortgage rates are set by lenders and markets, and tend to follow longer-term Treasury yields more closely than the Fed's rate.

Check your understanding

Answer each question from memory before opening it. Recalling, not rereading, is what makes learning stick (here's why).

1 When market interest rates rise, what happens to the price of an existing bond, and why?

It falls. New bonds pay the higher rate, so an older bond paying less is only attractive to buyers at a lower price.

2 In this guide's example, a 4% bond's price falls when rates rise to 5%. Which falls more: a 2-year, 10-year, or 30-year bond?

The 30-year bond, to about $846 per $1,000, compared with about $923 for the 10-year and $981 for the 2-year. Longer maturity means more sensitivity to rate changes.

3 What does the Federal Reserve directly set, and what does it influence?

It sets a target range for the federal funds rate, a short-term rate banks charge each other. That influences savings yields, credit card rates, and, less directly, mortgage rates and bond yields.

4 What's one tax advantage of US Treasury interest?

It's exempt from state and local income tax, though it's subject to federal income tax.

5 Why might you hold bonds even though stocks have historically returned more?

Bonds usually swing less than stocks and provide income, which can smooth a portfolio, especially as you get closer to needing the money.

Where to go next

You've finished the foundations of the Money & Investing path. Next:

Sources

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