Why do Interest Rates Change?

There are several types of interest rates. These include:

• Prime rate: The interest rate banks charge their best (prime) customers.

• Treasury bill rates: Treasury bills are short-term debt instruments used by the U.S. Government to finance their debt. Commonly called T-bills, they mature in less than one year.

• Treasury Notes: Intermediate-term debt instruments used by the U.S. Government to finance their debt. They mature in one to ten years.

• Treasury Bonds: Long debt instruments used by the U.S. Government to finance its debt. Treasury bonds mature in more than ten years.

• Federal Funds Rate: Banks with excess reserves at a Federal Reserve district bank charge this rate to other member banks for overnight loans.

• Federal Discount Rate: The interest rate the Federal Reserve charges its member banks for short-term borrowing to meet liquidity needs.

• Libor: London Interbank Offered Rates. Average London Eurodollar rates.

• 6-month CD rate: The average rate that you get when you invest in a 6-month CD.

• 11th District Cost of Funds: A weighted average of the actual interest expenses incurred for a given month by the savings institutions headquartered in the 11th District of the Federal Home Loan Bank System.

• Fannie Mae Backed Security rates: Fannie Mae pools large quantities of mortgages, creates securities with them, and sells them as Fannie Mae backed securities. The rates on these securities influence mortgage rates very strongly.

• Ginnie Mae-Backed Security rates: Ginnie Mae pools large quantities of mortgages, securitizes them and sells them as Ginnie Mae-backed securities. The rates on these securities influence mortgage rates on FHA and VA loans.

Interest rate movements are influenced by the fundamental forces of supply and demand. Given a fixed level of lendable funds, if the demand for credit (loans) increases, interest rates also increase. I.e., when more people (borrowers) bid for a limited resource (money) the cost of that resource increases. Conversely, if the demand for credit decreases, so will interest rates as lenders lower the cost to entice borrowing. When the economy expands there is a higher demand for credit and interest rates increase.  When the economy contracts, the demand for credit lessens and interest rates decrease.

A fundamental concept:

• Bad news (i.e. a slowing economy) is good news for interest rates (i.e. lower rates).

• Good news (i.e. a growing economy) is bad news for interest rates (i.e. higher rates).

A major factor driving interest rates is inflation. Higher inflation is associated with a growing economy. When the economy grows too rapidly, the Federal Reserve increases interest rates to slow the economy and reduce inflation. Inflation is the increase in the general level of prices for goods and services. When the economy is strong there is more demand for goods and services, so the producers of those goods and services can increase prices. A strong economy therefore results in higher real-estate prices, higher rents on apartments and higher mortgage rates.

Mortgage rates tend to move in the same direction as interest rates. However, actual mortgage rates are also based on supply and demand for mortgages. The supply/demand equation for mortgage rates may be different from the supply/demand equation for interest rates. This might sometimes result in mortgage rates moving differently from other rates. For example, one lender may be forced to close additional mortgages to meet a commitment they have made. This results in them offering lower rates even though interest rates may have moved up!