Interest rates play a big role in your finances. It affects everything from savings and money market rates, bond yields, mortgage rates, credit card rates, and even how you value a company and it’s stock price.
How market interest rates are set and the factors involved all play a role in what you earn on investments and pay on loans. It starts with monetary policy and the Federal Reserve.
Who Sets Interest Rates
The Fed uses monetary policy to manage the economy. When you here about the Fed printing money, it’s trying to increase the money supply to lower interest rates and increase lending, spending, and inflation.
To do the opposite, the Fed changes the federal funds rate. The federal funds rate is the rate banks charge other banks to borrow money. So a higher federal funds rate will lower the money supply and decrease lending, spending, and inflation.
A change in the federal funds rate doesn’t directly impact other market interest rates. Instead it causes banks to raise or lower the interest rate it charges customers. That includes the rate it pays on deposit accounts and the rate it charges for loans. From there it trickles down to other interest bearing assets.
But it doesn’t end there.
What Determines Interest Rates
There are a number of factors that go into interest rates. These are the most important:
Inflation
Over time the value of the dollar decreases based on the time value of money. Where a dollar today buys more than a dollar tomorrow. To offset the loss of purchasing power, inflation needs to be factored into interest rates.
When you buy a bond or open a CD, you want to grow your money. But you don’t want your money to grow at a rate equal to or less than inflation. You want to grow your purchasing power too. To avoid that, an inflation risk premium is added into interest rates.
The premium should be high enough to offset any expected changes in inflation over the life of a loan or bond. Unfortunately, once you’re locked in, those interest rates offer little protection from extreme changes in inflation.
Borrower Risk
The ability to pay back a loan is a big deal. A default risk premium is added for borrowers that have a higher chance of not paying back the loan.
When you get a mortgage the bank checks your income and credit report and adjusts the interest rate accordingly. A person with a higher chance of default will be charged a higher borrowing rate.
The same concept works for companies issuing bonds. You can check a company’s default risk by looking at its bond ratings, which is the equivalent of a credit report for corporate bonds.
Time Period
This is the length of a loan. For bonds, it’s known as time till maturity or duration. Either way, a longer time period results in a higher rate. You want a higher interest rate for lending money to a company for ten years than if you only lend money for one year.
The reason is simple. Interest rates change all the time. A long time period offers a higher chance that rates can rise, causing you to miss out on earning more money. This is known as interest rate risk. So a risk premium is added to longer duration CDs, bonds, and loans. It won’t remove the risk entirely. Which is why you see the daily fluctuations in the price-yield relationship of bonds as interest rates move.
Taxes on Interest
The interest you receive from savings accounts, CDs, and bonds is taxable as income. But it’s not always the case. The tax code provides favored status to certain tax-free bonds. For example, you don’t pay federal taxes on interest earned from municipal bonds.
Once the other risk factors are considered the tax-free benefit needs to be accounted for as well. Once taxes are considered, a municipal bond with a lower interest rate could pay just as much or more interest than a taxable bond because of your marginal tax rate. That is why it’s important to take into account the tax equivalent yield of a municipal bond.
Add It All Up
Any time one of these factors changes, it causes a domino effect across market rates. If you’re looking for bond yields to change or just want to lock in a mortgage rate, keep an eye on the factors that change market interest rates.
