Interest rates are typically determined by a central bank in most countries. In the United States, a forum is held once per month for eight months out of the year to determine interest rates. At this time, the economic status of the country is assessed, and interest rates are adjusted according to the needs of the country. The panel that determines interest rates consists of representatives of the Federal Reserve Board and the Federal Reserve Bank. Together, the representatives from both form the Federal Open Market Committee.
The Federal Reserve monitors and sets standards for monetary policy in the United States. There are 12 Federal Reserve Banks located in major cities around the country. Although the Federal Reserve undergoes reviews by Congress, the organization is an independent entity. Therefore, they do not need the President’s approval or any other branch of government before making decisions about the economy.
There are seven members of the board. Each member is appointed by the President to the Board of Governors and serves up to 14 years per term. They can be reelected. The board is headed by a President and Vice President. Each can hold office for 4 years and can be reappointed by the Senate. Ben Bernake currently serves this role and is the successor to Alan Greenspan.
The Federal Reserve monitors and generates income from several entities. They earn dividends on foreign currency, loan interest collected, services, and interest from government securities. If the Federal Reserve posts a profit above and beyond its operating costs, then those funds are redirected to the U.S. Treasury.
The goal of each monthly meeting is to determine the liquidity of funds within the country and establish prices that will keep the economy stable. If the circulation of money within the country is abundant, the prices will increase. If the circulation of money within the country is minimal, the prices will decrease. The goal is to find a balance that will keep the economy stable and achieve full employment.
The central bank lends money to retail banks at a discount interest rate. The consumer in turn borrows from the retail banks. The interest rates or Prime Interest Rates are determined by the rates assigned by the central bank to the retail bank. The central bank will raise interest rates when they want to discourage consumer borrowing and encourage more deposits. The deposits contribute to the overall worth of the bank. When the consumer deposits money, the bank can lend this money to another party to generate income from interest collected. The central bank will lower interest rates when they want to encourage consumer borrowing and increase spending.
Inflation is also another factor driving interest rates. When the Federal Reserve predicts inflation, the interest rates are typically high. If the currency is losing purchase power, the banks must compensate for what the currency will be worth when the full amount of interest is collected.
Ever since 2010 experts have predicted the economy would rebounded. However, each year such predictions get moved back as financial asset prices increase while the regular economy lags behind. The Federal Reserve stopped their 3rd round of quantitative easing in 2014 and have slowly lifted rates since while winding down their balance sheet. They raised rates 4 times in 2018 to counteract the stimulative impacts of the 2017 Tax Cuts and Jobs Act, though they are likely to move slowly with rate increases going forward in order to not disrupt the financial markets.
The mortgage rates vary depending upon the type of loan that will be acquired by the consumer. For instance, in February, 2010, the national average mortgage rate for a 30 year fixed rate loan was at 4.750 percent (5.016 APR). The 15 year fixed is currently at 4.125 percent (4.312 APR) and the 5/1 ARM is at 3.875 percent (3.122 APR). These prices are just a snapshot of the average and will change. Therefore, it is best to research the average and know what the rates are prior to selecting a loan. The follow chart shows trends over the past 20 years.
Fixed rate mortgages are based upon the national average, but vary from state to state. These mortgages possess the same interest rate throughout the duration of the loan. Consumers desire these loans if they plan to remain in their homes for the duration of the loan. For example, the consumer obtains a mortgage when interest rates are at their lowest and then interest rates rise. The consumer does not have to worry about their mortgage rates increasing because the interest rate is “fixed”. If the interest rates decrease, the consumer may have the option of refinancing, if the costs of refinancing are less than the overall savings.
These loans are typically available in 15 year and 30 year loan options. The rates are higher than variable rate loans. The longer the term, the higher the rate, because banks will lose money as purchasing power decreases over time due to inflation.
Adjustable rates typically start off lower than fixed rates when the loan is initially established. ARMs may adjust on a monthly, bi-annual, or annual basis in keeping with the Federal Reserve or be indexed against other rates like LIBOR. The consumer should be aware that as interest rates increase, so will the monthly mortgage. While ARMs may be appealing because the rates are lower, ARMs can also be a gamble that rates will not rise. If rates rise, then the monthly payments also increase. ARMs may be beneficial to investors or consumers who only plan to keep the loan for a short period of time. During this time, the consumer can enjoy low interest rates. You can calculate the impact of different rate changes using this free tool.
Hybrid Adjustable Rate Mortgages offer the consumer a low interest rate for a certain period of time. Then, they increase or adjust to the current rate after fixed rate period has elapsed. These rates can be an entire point lower than 30 year fixed rates. Therefore, there may be significant savings in terms of interest paid to the lender. Some common hybrid ARMs are 1 year fixed, 1 year adjustable rates (1/1); 5 years fixed, 1 year adjustable (5/1); and 7 years fixed, 1 year adjustable (7/1). The adjustable rates will be based upon the federal rate when the fixed term elapses. These loans are also appealing to investors or home buyers who plan to sell in a short period of time.
The FHA secures loans made by private lenders. These loans are provided to Americans who have a low to middle income. This loan is available to those people who cannot afford a large down payment or higher interest rates. Interest rates for these loans are lower than the National Average for a Fixed Rate Loan. Individual banks determine the interest rates; therefore, the consumer should do research prior to accepting a loan at a particular bank. The consumer can receive a loan for as little as 3 percent down and also receive as much as 6 percent on closing costs. This means that the consumer can borrow up to 97 percent of the cost of the home. We offer an FHA qualifier tool here.
VA loans are offered to veterans. The loans assist veterans in obtaining 100 percent financing. The United States Department of Veterans Affairs is the governing body that establishes the rules for the recipients of the VA loans. They also insure the VA loans and establish the terms of the loans offered to veterans.
Fixed rate mortgages are best for individuals who intend to remain in their homes for the duration of the loan. The interest rate may be higher than an ARM; however, there will be no hidden mortgage increases over the duration of the loan.
During the fixed rate period of a hybrid ARM, the consumer can enjoy the low interest rates and low mortgage payments. However, individuals who are not prepared may see an increase in their mortgage premiums that they cannot afford.
ARM mortgage interest rates change each month with the Federal Reserve. This loan is typically recommended for a short term investor who will sell quickly.
Fixed rate loans are by far the safest loans for consumers over a period of time.
The best time to secure a mortgage is when the rates are the lowest. Compare the National Mortgage Rate average over the past 10 -20 years. If the rate is at one of its lowest points historically, then it can be a safe entry point into the market. Many investors purchased when the market was low, but it had not reached its lowest point. Now, home buyers owe more than the house is worth. Those who wish to sell cannot fully recoup the costs of the home. Therefore, instead of having equity in the home, consumers owe more than the home is worth. Many individuals, in this instance will negotiate with the bank and “short sell” in order to relieve themselves of the debt.
As stated above, the rates change based upon the Federal Reserve and the desire to keep the economy stable. Read the reports from the office and inquire with lenders to get a fair prediction of the direction of the Federal Reserve. If the Federal Reserve decides that consumers need to spend and borrow, interest rates will remain low. However, if the Federal Reserve decides that it needs consumers to save, invest, and deposit money, the interest rates will remain high.
Beware of Adjustable Rate Mortgages (ARMs). The rates will increase after the introductory period and may cause a home buyer financial stress when the mortgage rates increase. Some individuals even foreclose when this happens, because they cannot handle the increase in the mortgage costs.
Other hidden costs may be associated with refinancing. For instance, an individual with a fixed interest rate may decide to refinance the loan if the interest rates decrease during the duration of the loan. However, the consumer must incur costs to have the loan refinanced. The consumer should make certain that the cost of refinancing is less than the savings from a lower interest rate. Otherwise, refinancing may not be in the best interest of the consumer.