How Do Interest Rates Fluctuate?
Interest rates at any one financial institution can fluctuate on a daily basis due to a variety of underlying factors. The policy makers at the Federal Reserve, the level of demand in the debt market and the financial strength of banks are factors that have an impact on interest rates.
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How Interest Rates Work
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Financial institutions operate as both borrowers and lenders. Banks borrow money from consumers by offering to pay interest rates on products such as certificate of deposit, or CD, accounts. They also borrow money from other banks and from the Federal Reserve. Banks generate profits by lending out borrowed funds to other institutions, businesses or individuals. The interest rates banks pay to borrow money are lower than the rates banks charge and it has to remain that way if banks are to stay profitable.
Federal Reserve
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The Federal Reserve Open Market Committee determines the Federal Funds Rate, which sets the benchmark for interbank lending. Banks acquire money from the cheapest source, so if the Federal Funds Rate falls, CD rates must fall; otherwise, banks would just borrow money from the Federal Reserve. Generally, the Federal Funds Rate falls if the government is trying to make borrowing cheap so as to boost lending and rises if inflation becomes a problem because higher rates slow down spending. Banks with low credit ratings have to pay a higher interest rate than healthy banks, so struggling banks often raise CD rates to attract customers because federal borrowing becomes too expensive.
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Mortgage Rates
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Most mortgages are paid off in less than 10 years either because home buyers actually pay down the loan early or because they sell the home. Bonds tied to mortgages are therefore most comparable as investment instruments to 10 year Treasury bills. However, because consumers are perceived as being more likely to default on loan payments than the federal government, mortgage rates are usually priced at 1 1/2 percent above 10 year Treasury rates. Treasury rates are driven by supply and demand, so when supply exceeds demand, rates fall and this causes mortgage rates to fall. The opposite occurs when supply outstrips demand.
Other Interest Rate Factors
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During severe recessions, defaults on home loans rise and banks become wary of taking on new loans because of the risks involved. To reduce the level of risk, banks limit the amount of loans available and raise rates significantly, even if market forces do not support such high rates. Many foreign investors and governments buy U.S. currency and bonds. If the value of U.S. currency falls on the exchange market, rates must rise to attract investors. Additionally, some banks borrow money from overseas at rates determined by indexes such as the London Interbank Offered Rate, but these rates effectively rise when the dollar falls as a result of being pegged to foreign currencies.
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