Q&A of the Day – How Interest Rates Work
Each day I feature a listener question sent by one of these methods.
Email: brianmudd@iheartmedia.com
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Today’s Entry: Brian- question for you. I get that the fed rate affects what lenders charge for loans but how does the process actually work? Does the Federal Reserve get to dictate the minimum of what lenders charge?
Bottom Line: No, not exactly but it more or less has that effect on the financial markets. Yesterday, as expected, the Federal Reserve left interest rates unchanged at 21-year highs while leaving the door open to future rate increases. The effective Federal Funds rate most recently stands at 5.33%. That’s not a dictate to financial institutions as to the minimum interest rates they should charge. It’s the cost of money to the financial institutions from the Federal Reserve. There's a fair amount of confusion that comes into play regarding how interest rates work, but it’s not really that complicated.
The lenders that you borrow money from mostly borrow that money from the federal government. The “capital requirement” for banks is 4.5%. What this means is that a bank only needs to hold 4.5% of the total amount money that’s lent out. Banks leverage the money they have on their balance sheet by borrowing funds from the federal government that they then lend to you. The "Federal Funds rate" is the rate those lenders have to pay the feds to borrow the money. Whatever your lender charges you for the loan you receive is the markup based on the market factors for your risk profile, the type of loan and competition in the marketplace.
The four key considerations in determining the cost of loans are these:
- Cost of the money being lent
- Credit risk of the people or entity borrowing funds
- Whether the loan is secured or unsecured
- Profit margin for the lender
With the wholesale cost of money to lenders currently coming in at 5.3%, it effectively works as a floor for what rates financial products will cost. And as we look at what the average cost of borrowing currently is based on the type of loan product it ties the explanation together.
Average interest rate by loan type:
This illustrates the difference between two secured loans vs. two types of unsecured loans. The average mortgage rate is only 2.5% higher than the borrowing cost for lenders because it’s secured with what’s a generally appreciating asset that the bank can take possession of if the loan is defaulted on. You see that the cost of a typical auto loan bumps up a bit from that of a home loan. While an auto loan is secured by the vehicle, unlike a home, it’s a generally depreciating asset. That presents greater risk of loss to the lender in the event of a default and thus a higher rate. And that takes us to the two generally unsecured types of loans which also come with much higher average interest rates.
In the event that a personal loan or credit card is defaulted on, there’s the potential for a total loss of the money lent. Personal loans tend to carry much lower rates than credit cards, as is currently the case with a ten-point spread between the two, due to the way they’re issued. Those with poor or fair credit often must put up collateral to obtain them (creating a secured loan), while those with good or excellent credit are able to obtain unsecured personal lines of credit. And then there’s credit card interest rates. They’re notoriously high during good times, they’re especially high during periods of elevated interest rates. That’s due to their status as an unsecured line that’s also the most likely to be defaulted on.
Speaking of which... Here are the default rates for each loan type:
You’ll notice that default rates follow the rates that are charged for these loans. What this also illustrates is what percentage of people are under severe financial distress. Just over 7% of people aren’t able to pay all of their bills while just under 2% are under maximum financial duress as they’re struggling to maintain the roof over their heads. As these rates fluctuate, lending standards tend to change. And on that note, it’s not just that interest rates are the highest they’ve been in over twenty years. It’s that we’re starting to see default rates on various loan products that are the highest in many years as well. The current credit card delinquency rate is the highest since 2012, when people were still recovering from the impact of the Great Recession. As a result, you’re likely to see lending standards rising, in addition to the amount of credit that’s extended dropping.
So, there you go. That’s how interest rates work...from the Federal Reserve to the loan of your choice.