When discussing bank accounts, investments, loans, and mortgages, it is important to understand the concept of interest rates. Interest is the price you pay for the temporary use of someone else’s funds; an interest rate is the percentage of a borrowed amount that is attributable to interest.
The Purpose of Interest
Although borrowing money can help you accomplish a variety of financial goals, the cost of borrowing is interest. When you take out a loan, you receive a lump sum of money up front and are obligated to pay it back over time, generally with interest. Due to the interest charges, you end up owing more than you actually borrowed. The trade-off, however, is that you receive the funds you need to achieve your goal, such as buying a house, obtaining a college education, or starting a business.
To a lender, interest represents compensation for the service and risk of lending money. In addition to giving up the opportunity to spend the money right away, a lender assumes certain risks. One obvious risk is that the borrower will not pay back the loan in a timely manner, if ever. Inflation creates another risk. Typically, prices tend to rise over time; therefore, goods and services will likely cost more by the time a lender is paid back. In effect, the future spending power of the money borrowed is reduced by inflation because more dollars are needed to purchase the same amount of goods and services.
Supply and Demand
Interest rates often fluctuate, according to the supply and demand of credit, which is the money available to be loaned and borrowed. In general, one person’s financial habits, such as carrying a loan or saving money in fixed-interest accounts, will not affect the amount of credit available to borrowers enough to change interest rates. However, an overall trend in consumer banking, investing, and debt can have an effect on interest rates. Businesses, governments, and foreign entities also impact the supply and demand of credit according to their lending and borrowing patterns. An increase in the supply of credit, often associated with a decrease in demand for credit, tends to lower interest rates. Conversely, a decrease in supply of credit, often coupled with an increase in demand for it, tends to raise interest rates.
The Role of the Fed
As a part of the U.S. government’s monetary policy, the Federal Reserve Board (the Fed) manipulates interest rates in an effort to control money and credit conditions in the economy. Consequently, lenders and borrowers can look to the Fed for an indication of how interest rates may change in the future. In order to influence the economy, the Fed buys or sells previously issued government securities, which affects the Federal funds rate. This is the interest rate that institutions charge each other for very short-term loans, as well as the interest rate banks use for commercial lending. For example, when the Fed sells securities, money from banks is used for these transactions; this lowers the amount available for lending, which raises interest rates. By contrast, when the Fed buys government securities, banks are left with more money than is needed for lending; this increase in the supply of credit, in turn, lowers interest rates. Lower interest rates tend to make it easier for individuals to borrow. Since less money is spent on interest, more funds may be available to spend on other goods and services. Higher interest rates are often an incentive for individuals to save and invest, in order to take advantage of the greater amount of interest to be earned.
Relationship to Prime Rate
While most variable-rate bank loans aren’t directly tied to the federal funds rate, they usually move in the same direction. That’s because the prime and LIBOR rate, two important benchmark rates to which these loans are often pegged, have a close relationship to federal funds.
In the case of the prime rate, the link is particularly close. Prime is usually considered the rate that a commercial bank offers to its least-risky customers. The Wall Street Journal asks 10 major banks in the U.S. what they charge their most creditworthy corporate customers. It publishes the average on a daily basis, although it only changes the rate when 70% of the respondents adjust their rate.
While each bank sets its own prime rate, the average consistently hovers at three percentage points above the funds rate. Consequently, the two figures move in virtual lock-step with one another.
If you’re an individual with average credit, your credit card may charge prime plus, say, six percentage points. If the fed funds rate is at 2.25%, that means prime is probably at 5.25%. So our hypothetical customer is paying 11.25% on their revolving credit line. If the Federal Open Market Committee (FOMC) lowers the rate, they will enjoy lower borrowing costs almost immediately.
The LIBOR Connection
While most small and mid-sized banks borrow federal funds to meet their reserve requirements or lend their excess cash, the central bank isn’t the only place they can go for competitively priced short-term loans. They can also trade Eurodollars, which are U.S.-dollar denominated deposits at foreign banks. Because of the size of their transactions, many larger banks are willing to go overseas if it means a slightly better rate.
London Interbank Offered Rate (LIBOR) is perhaps the most influential benchmark rate in the world, is the amount banks charge each other for Eurodollars on the London interbank market. The Intercontinental Exchange (ICE) group asks several large banks how much it would cost them to borrow from another lending institution every day. The filtered average of the responses represents LIBOR. Eurodollars come in various durations, so there are actually multiple benchmark rates such as 1 month, 3 month, 6 month and 1 year LIBOR.
Two of the most prominent benchmark rates, prime and LIBOR, both tend to track the federal funds rate closely over time. However, during periods of economic turmoil, LIBOR appears more likely to diverge from the central bank’s key rate to a greater extent.
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