So Wait, What Actually Are Interest Rates

 

Interest rates are one of the most powerful tools not only in the world of business and the function of economies, but also in the economic theory that underlies what goes on every day. To understand interest rates is to understand both how to make money and how money is made. Unfortunately, while some people have some grasp with the concept, far too few can really explain what interest rates are, how they are set, and why they matter. So to that end, here is a guide on how to understand and make the most of this one crucial instrument.

 

What Are Interest Rates?

“The most direct indicator of social time preference is the rate of interest” – Hans Hermann-Hoppe, Austrian School of Economics

 

In the most basic sense, interest is the cost of borrowing money, the lease paid to use money now, with the promise to pay back that amount and more in the future. The interest rate is the percentage of the initial, principle amount that you pay as interest.

 

Interest is charged to pay for the lender’s loss of the asset for the time the borrower will have it. In one sense, it’s a measure of the opportunity cost of not having the money. The lender could, instead of lending to you, lend to plenty of other people and organizations who promise different rates of return, or just save the money, where the bank would pay interest on it. So, because the lender doesn’t do any of those things and instead decides to lend you the money, you are charged interest to make it worth the lender’s while in the first place.

 

How Are Interest Rates Set?

 

The means through which commercial banks determine the interest rates on loans, including on mortgages, is a complicated process involving the Federal Reserve, public bond rates, and general economic conditions, only lastly adjusted for the individual circumstances of borrowers.

 

First, the central bank of a region, such as the US Federal Reserve, unilaterally sets the rate at which banks can lend money to each other on a daily basis to meet their minimum requirements. This rate is termed the Fed Funds rate, and it is the single most important interest rate in the world, as it underlies or affects every other rate on the market.

 

The Fed Funds rate isn’t determined directly by the market, but by the decisions of the Federal Reserve Open Market Committee, and the sale or purchase of Federal Reserve Notes from private banks. Through buying and selling bank securities, the Federal Reserve is able to systemically affect interest rates, causing them to approach the Fed’s desired levels.

 

To Lower Rates: If the Fed buys a bank’s securities and deposits credit in the bank’s accounts, that bank has more funds and needs to lower its rates to approach the target Fed Funds rate to be able to lend out money.

 

To Increase Rates: If the Fed sells its securities holdings and removes funds from a bank’s balance sheets to pay for those securities, that bank has fewer funds and thereby has to increase interest rates to approach the target Fed Funds rate.  

 

The following are directly affected by the Fed funds rate:

 

  • LIBOR: The London Interbank Offering Rate is the rate banks charge each other for one-month, three-month, six-month, and one-year loans, and it is usually just a few tenths of a percentage point above the Fed Funds rate.
  • Prime Rates: The Prime Rate is the rate that a bank charges its best customers. It is higher than the Fed Funds rate, but lower than the average variable rate.
  • Short-term or variable rate loans: The interest rates on variable rate or short-term loans are impacted by the prime rates, and tend to be a few points higher. If the Fed funds rate changes, the Prime rate changes, and therefore the rate of variable interest loans change. If you have a variable rate mortgage, for instance, the fluctuations of the interest rate you pay is based in part on the changes to the Fed funds rate.

 

However, the long-term mortgage market is not directly affected by the Fed funds rate, but rather by the market for Treasury Bonds, or other public government debt.

 

The rate of 15-30 year government Treasury Bonds sets the floor rate for long-term interest rates. As Treasury Bonds are the safest possible investment, they will always be the safe alternative investment. Therefore, in order to be profitable for a lender to issue a mortgage, it has to have a higher interest rate, and thus a higher rate of return, than merely investing that money in Treasury Bonds. If a borrower chooses a fixed rate mortgage, the interest rate on that mortgage will be based on the interest rate of Treasury Bonds at that time.

 

Why Interest Rates Matter?

 

Interest rates underpin much of the entire economy, as they are the “cost” of money, and thereby control the flow of money throughout the economy. High interest rates lead to less borrowing, more saving, and a slower economy as companies stop investing and even cut back on production, potentially resulting in higher unemployment. Low interest rates, on the other hand, stimulate more borrowing and faster economic growth, promoting investment and job creation, but also potentially leading to inflation as more money becomes available. The Federal Reserve and other central banks keep a close eye on interest rates to make sure that, whether they are increasing or decreasing, they’re always within safe bounds.

 

However, there is another interesting theory about interest rates from the Austrian School of Economics (which is not so much an actual school but an intellectual tradition) that proposes interest rates as a measure of civilization. Interest rates are fundamentally a measure of risk, as risky investments without a certainty of success and repayment would demand a higher interest rate than safe investments where repayment is more likely. Thereby, the safer a society becomes, the more forward thinking and prudent, the more civilized, the lower the general rate of interest will be. This fascinating theory has held up well against historical data: 6th century BC Greece had minimum interest rates on “safe” loans at 16%. Roman minimum interest rates during the height of the empire were 4%, while 13th century “late Dark Age” European minimum interest rates were 8%. This fell to 5% by the 14th century, 4% by the 15th century, 3% by the 17th century, and finally 2.5% by the 19th century. As Hans-Hermann Hoppe states, “Specifically, the trend toward lower interest rates reflects the rise of the Western World, its peoples’ increasing prosperity, farsightedness, intelligence, and moral strength, and the unparalleled height of 19th-century European civilization.” This is a fascinating theory, and a good way to help comprehend the idea of interest rates more intuitively.

 

How Interest Rates Affect You

 

Of course, when you are borrowing money, you will have to take interest rates into account. The single most important time most people have to borrow money is on a mortgage. While there isn’t much you can do to affect the fundamentals of how interest rates are determined, you can determine whether you get a good rate or a bad rate. Beyond the Prime rate or the Treasury Bond rates, banks are free to set interest rates however they like, but are still subject to market competition. If you can demonstrate to a bank that you are a safe bet to repay your mortgage and the interest on it, they will offer you a lower rate to get your business. The best way to prove to the bank that you’re a reliable borrower is to have a strong credit history, a sizeable downpayment, and using many other services from the bank (checking, savings, credit, etc) to get a discount. Finally, it might be best to seek a mortgage during an economic downturn, when most people aren’t borrowing and banks are lowering interest rates attempting to get business. When banks need more borrowers, you’ll have more leverage to negotiate lower rates.

 

Finally, remember that all macroeconomic machinations aside, banks set their own interest rates, and are in competition for your business. The lower the interest rates they offer, the lower the “price” of borrowing money. Shop around from a number of banks and see if you can get a lower price, just as you would when purchasing anything from a car to a pair of jeans. After all, what you’re looking to buy, a home, will likely be the largest single expenditure in your life. Best to get it for as little as possible.

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