For those who are considering purchasing a home using a mortgage, there is a lot of talk about the interest rates that accompany this type of loan. You probably have read many articles which discuss the best interest rate for mortgages and when is the best time to buy a home. But what exactly is the interest rate, who sets it, and why does it change over time?
What it the Interest Rate?
Essentially, the interest rate is the price that a lender charges to a borrower to use their money. This is the way that a lender makes money through the loan process and the higher the rate, the more money they will earn. For example, if you borrow $1,000 with an interest rate of 5% your payback of the loan will include $50 per year based on the 5% rate.
Naturally, the higher the rate, the more money you will have to pay back on the loan which is why borrowers are always looking for the lowest interest rate they can find. It is also true that interest rates vary depending on the type of loan that is made such as a home mortgage, auto loan, credit card, and so forth.
Who Sets the Interest Rate and How?
The Federal Open Market Committee (FOMC), which is an arm of the Federal Reserve, sets interest rates for the banks and other lending institutions to follow. Although, to be accurate the Fed does not actually set the rates, but instead creates a target for the rates for federal funds and then either creates or destroys money so that it reaches the desired goal. The rate is set through a number of different factors, but in the end banks and lending institutions follows the federal rate for the interest that they charge on loans.
The FOMC consists of seven members of the Federal Reserve Board along with five of the current twelve presidents of Federal Reserve Banks. Created in 1933 and revised in 1935 and 1942, the formation of the FOMC was designed to help stabilize the economy. The result has been a more stable method of selecting interest rates that would be followed by other banks and lending institutions. There is nothing that states that a bank or lending institution must set their rates according to the FOMC, but there is little incentive to go much higher than the rate for competitive reasons.
The committee meets roughly every six weeks, although only four times are mandatory. Special or emergency meetings can be called for depending on the circumstances where quick action is needed. However, given the space between the meetings, it encourages the members to think ahead and plan for the future when setting new rates.
How Past Increases to the FFR Affected Short Term Treasury Securities and Mortgage Rates Over Time?
When it comes to how interest rates have affected the Federal Funds Rate (FFR), it can be dramatically shown since the 1950s that it has reflected money concerns with a changing economy. The most dramatic rise in the interest rates occurred in the late 1970s/early 1980s when inflation reached its peak. It was at that time when there was too much money in the economy and it devalued the dollar to such an extent that the interest rates skyrocketed.
Both before and after that time, interest rates have been modestly low usually falling under 4%. Today, the interest rates are arguably lower than they have ever been at least in the past 50 years. Only recently has there been a quarter-point boost in the interest rates by the Feds which has been done to help curb potential inflation from a rising economy. It is predicted that the interest rates will go up by a quarter-point over the next year until they reach 1%, but that could change dramatically depending on the overall economy.
The three-month Treasury rate since World War II has mirrored the rise of interest rates to mortgages over the same period of time. There was a general rise, leading to a sharp spike at the beginning of the 1980s, followed by a free fall until today where they have bottomed out much like they were just before the outbreak of World War II.
In terms of mortgage rates, the early 1970s had them at a somewhat high 7.5%, which skyrocketed in the early 1980s to over 17.5% until they fell over the next thirty years down to roughly 3% where they have held steady. As with the federal funds and treasury notes, the mortgage rates mirror the economic times in which the country underwent a few recessions and economic booms. In the end, the macro economy is the driving force behind the rates set by the Federal Reserve.
How Mortgage Rates Correlate to 30-Year Treasury Security?
When compared to 30 year treasury security, mortgage rates have been fairly stable over the past 30 year running at a rate considerably lower than Treasury yields over the same period of time. There are a number of reasons why this is happening, but for those who are thinking of purchasing a home, the low rates are quite attractive.
Compared to the treasury yield curve over the same period of time, the yield has steadily gone upwards in both nominal and real charts that make it a good investment. When you compare the rate of mortgages, the factors are different because the investment in purchasing a home involves different factors. Treasury rates are for direct investing while homes are mostly considered personal property that also may be investments in and of themselves.
The interest rates that are set by the FOMC are crafted from many different factors in the economy. Generally speaking, times of recession or low economic growth have low interest rates while economic booms or too much money in the economy tends to make the rates soar. However, that is not always the case and it certainly benefits consumers to pay attention to the Federal Reserve when it comes to setting interest rates.