by Adam Netland
You may be reading in the news lately how Federal Reserve Chairman Ben Bernanke and the Federal Reserve have been cutting interest rates and may wonder how this affects your mortgage, credit cards, or investments.
The Federal Reserve’s key role is to control the amount of money in the banking or economic system. The Fed changes the discount rate to make it more or less profitable for commercial banks to borrow money. The banks use this borrowed money to make loans or investments at a higher interest rate to their customers.
So why are some investments affected differently than others, and why do rates change over time? Interest rates are influenced by how long the money is being loaned, who the money is being loaned to, and what rate money might be loaned at in the future. The following should help in understanding these different influences.
The time value of money: Basically, this means a dollar now is worth more than a dollar in the future. In order to loan a dollar today, you should be compensated above and beyond that dollar as time goes on.
Credit risk of the borrower: Some borrowers will default on payments; those with a perceived higher risk are charged a higher rate. Even though the Fed Fund’s rate has declined recently, mortgage rates haven’t fallen, because the issuers of those loans are requiring higher rates to compensate for the perception that mortgage borrowers will not be able to pay back the loan or will default in some other way.
Inflation risk: This is the risk that inflation will undermine the performance of an investment. A lender will want to charge a rate that will return the desired rate after inflation, so interest rates should be higher when inflation is expected to be higher. This is generally why loans with longer time frames have higher interest rates than shorter-term loans.