Are Interest Rates Headed Up? Should I Care?

What is interest, anyway?

I'm starting this post with a definition of interest, because many folks out there on the fruited plains don't really understand what interest is, what affects interest rates, and how interest rates affect us. To most people, "interest" has acquired a negative connotation, as it denotes the extra we pay to borrow money. Increases in interest rates tend to bring groans, and decreases, relief.

The definition of interest is simple: interest is the cost of money (specifically, using someone else's money). When you borrow money, you are "renting" the money in the same way you "rent" a DVD or car. You are using something that belongs to someone else, for a set period of time, and paying them for the privilege. The price you pay depends on market conditions (usually the costs incurred by the provider in bringing the product to market and maintaining it). In the case of renting a car, the rental company has to maintain the car, takes a hit on depreciation, and runs the risk that you'll wrap it around a telephone pole. Those costs, plus the company's profit margin, are factored into your rental rate.

The same overall set of forces drive the price of money, but there are some differences. One of the major determinants of interest rate is the level of risk involved that the borrower will default and the lender will be unable to recover its loan. This is why a consumer with a high credit score putting 10% down on a new house can secure a low interest rate: the consumer has shown him or herself to be trustworthy and reliable, and if push comes right down to shove and the borrower gets hit with a garbage truck, there's still the house itself as collateral. So the lender can get away with a small risk premium.

Another factor determining interest rates is inflation, which is something Netflix doesn't have to worry about. The value of that copy of I Am Legend that you rented on Tuesday isn't going to change significantly by the time you return it on Saturday. Not so with money, especially over time. If you're over 40 or so, you know exactly what I'm talking about. In the Seventies, you could do dinner and a movie with your sig.other on $20. Now movie tix and popcorn alone would run close to $25. So, if you loan someone $100,000 today, charge them 4%, with the loan due in 2018, you're not going to make 4%, because the value of those loaned dollars is being chipped away at every year by inflation. In fact, if inflation runs at 5%, even if the loan is repaid as agreed, you've lost money, because the dollars you were owed were depreciating more quickly than the interest you charged was adding up.

So how do lenders know what inflation will be like the next ten years? They don't. But because interest rates factor in inflation, they also factor in the big banks' guesses at to what inflation is going to be doing. Because there are billions of dollars on the line, you can bet banks have some of the best economic minds on retainer to game out where interest rates are headed, but after all is said and done, it's only an educated guess. They could come out ahead...or behind. But the moral of the story is, when long-term interest rates start going up, that's a signal that the Big Boys expect more inflation down the road. On the other hand, if long-term rates remain low, that means the banks are relatively unconcerned with inflation down the road.

There's a third factor figuring into interest rates, and that is the Federal Reserve. The role the Fed plays in the economy is too complex to go into here, but for the purposes of our discussion, think of the Fed as a reservoir of money, upstream from the rest of the economy. As a reservoir serves to moderate the flow of the river downstream, so the Fed moderates--or tries to moderate--the economy. When the economy runs too slowly (the "river" starts to dry up), the Fed opens the spillways and releases money. When the "river" runs high, and "excess" growth threatens to spur inflation, the sluice-gates are constricted, and the Fed draws more money to itself.

Operationally, what the Fed does to loosen or tighten the flow of money is to lower and raise, respectively, the interest rates it charges to the banks. The Fed also engages in what are called open-market transactions, selling U.S. Treasury bonds to suck money out of the economy when it wishes to tighten the money supply, and buying bonds to sluice money back out. These measures act, usually quickly, to affect the prime rate, which is the interest rates the banks charge their biggest, best, most reliable customers. Most other interest rates are pegged to the prime (with some level of markup), so changes in the prime rate richochet rather quickly through the economy.

However, mortgage rates are relatively insensitive to the prime rate. Why? Because mortgage rates are a 15 to 30-year "bet," the "odds" on the table today really don't matter much to mortgage lenders. (A nominal exception to this are ARMs (Adjustable-Rate Mortgages); since interest rates can be adjusted over time, the initial rate does more closely correspond with current market conditions.) The 30-year fixed mortage interest rate offers the average consumer the best look at what the experts (the ones with a lot of casino chips on the table) see as the future of the economy.

So when you see the 30-year fixed rate increase sharply, you should be seeing a red flag. Such an increase means that the Big Boys see trouble over the horizon (higher inflation, more economic uncertainty, a possible nosedive causing higher defaults that need to be factored into the risk premium, etc.).

This is why I have a widget posted in the right column of this blog, tracking interest rates over time. In fact, it shows the very phenomenon I've been alluding to. Note how the ARM rates have been fluctuating around a mean, whereas long-term rates have noticeably increased over the last six months. In fact, the 30-year fixed rate has gone from around 5.9% in March to 6.35% at the end of last week.

How worried should we be? At this point, I don't consider the increase to be overly alarming. Recall that we have been operating for several years in an environment of unusually low interest rates. Through much of the Nineties, 30-year rates fluctuated between 6.5% and 9%. So the increase to 6.35% isn't much to get worried about--for now.

However, this statistic bears watching, as further run-ups in the 15 and 30-year rates could mean that knowledgeable people in high places see trouble up ahead.