Why do interest rates change so frequently?
Interest is the price borrowers pay to lenders for the use of their money. It allows borrowers to make purchases that they could not afford if they had to pay immediately. Interest is calculated as a percentage of the loan amount. For example, a borrower who is charged 10 percent interest would pay $10 a year in interest for every $100 of loan amount. Interest is based on the concept that lenders are entitled to a return on their investment. Interest compensates a lender for giving up their right to use the money for a period of time or to use that money to generate profit in other ways. Interest plays an essential part in commerce. Business, consumers and governments borrow and lend money, and thus pay and receive interest. Institutions or people who grant loans have incomes greater than their expenditures, so they let others use their money. Instead of keeping or spending their surplus funds, lenders use it to generate more income through interest. Smart consumers should learn as much as they can about the interest rates that they agree to pay. Some merchants may try to make a profit by selling items at low prices but charging a high interest rates on credit payments. Many times consumers pay a higher interest rate for credit from a store than they would for a loan from a bank. Simple Interest The type of interest paid on loans is usually simple interest. Simple interest is paid only on the principal, the amount of money that is borrowed. A person who borrows $10,000 for five years at 10 percent simple interest would pay a total of $5,000 in interest. The amount of interest would be $1,000 (10 percent of $10,000) for the first year and $1,000 for each of the remaining four years. Amortized Loans Most mortgages and other consumer installment loans are amortized. An amortized loan is any loan with at least some portion of the payments going towards the principal. In a typical fully amortized loan, the debt is completely paid off by equal periodic payments over a fixed period of time. For example: A $100,000 loan at 8 percent interest, amortized over 30 years, would be fully paid off with 360 equal monthly payments of $733.76. Interest Rates Vary There are a number of loan markets, including those for home mortgages, consumer loans, government bonds, corporate bonds and foreign loans. Each loan market has its own interest rate, which rises and falls over time. The interest rates in these markets, like the prices of all commodities, depend on the relationship between supply and demand. Interest rates may rise if: The demand for loans increases. The amount of money available for loans decreases. Generally, when interest rates are low, people are eager to borrow because loans cost less than at other times. Interest rates may fall if: The demand for loans decreases. The amount of money available for loans increases. Usually, when interest rates are high, lenders are eager to make loans because they earn a larger profit. However, at the same time, loans cost more so people are less likely to borrow.
Supply and Demand
Supply and demand are affected by the following factors: Economic activity. When consumers buy more than previously, the economic activity of a country increases, and businesses expand their production capacity. To finance this expansion, they borrow. Therefore, the demand for loans increases and interest rates also rise. When the economy slows down, demands for products and services also slows. The demand for loans drops, and interest rates fall. Government Policy. Governments can influence interest rates by increasing or decreasing the money supply. When the money supply increases, interest rates drop. When the supply decreases, rates go up. Inflation. During periods of inflation, when prices are increasing in a country's economy, any given amount of money buys less than it did before. During these times lenders try to protect their incomes by raising interest rates. Amount of risk. Interest rates are also influenced by the creditworthiness of the borrower: The probability that the borrower will repay the loan. Length of a loan. For a give loan type, interest rates for short-term loans are typically lower than rates for long-term loans. Lenders believe they can foresee future economic conditions more accurately for a short period than a longer one. Consequently, they consider short-term loans safer.
The Secondary Mortgage Market
When a person borrows money from a lender, they must sign a promissory note as evidence of the debt (a promise to repay) and a deed of trust (or mortgage note) to serve as collateral for the loan. The holder of these documents has a legal claim to the property until the loan is paid in full. When a lending institution has loaned out all of its available funds, it will often raise money by selling groups of similar mortgages to investors. The selling of real estate loans to investors is referred to as the "secondary market." In order to attract investors, these secondary market financial products must be competitive with other similar investment opportunities. Since a mortgage is a long-term debt, the United States Treasury bond market (debt issued by the federal government) is used as a benchmark for determining appropriate value.
Mortgage Rates and Economic News
Inflation is the primary factor that affects both the U.S. Treasury bond markets and interest rate levels. Inflation makes bond investors nervous because it erodes the value of their fixed return investments. When the economy slows down, demand for products and services also slows. As a consequence, the threat of inflation is diminished and investors become more confident investing in long term debt. This is the reason U.S. Treasury bond prices move higher on weak economic news. When the price of bonds goes up an investor is forced to pay more for this investment, so its yield (return on investment) declines. When the yield on U.S. Treasury bonds declines, the return on all similar long-term investments (including mortgages sold in the secondary market) also declines. If a lender can sell home loans at a lower interest rate to investors, it is likely to pass on these lower rates to the borrower.
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