Southwest Montana Real Estate Blog

Libor: This is the rate banks charge each other for overnight loans to meet the Fed's reserve requirements. It is an acronym for the London InterBank Offering Rate. It is usually just a few tenths of a point higher than the Fed funds rate.

Prime Rate: What banks charge their best customers. It is usually above the Fed funds rate, but a few points below the average variable interest rate. Interest rates affect the economy slowly. When the Federal Reserve changes the fed funds rate, it can take 12 months to 18 months for the effect of the change to percolate throughout the entire economy. As rates increase, banks slowly lend less, and businesses slowly put off expansion. Similarly, consumers slowly realize they aren't as wealthy as they once were, and put off purchases.

Stock market analysts and traders watch the monthly Federal Open Market Committee meetings closely. A 0.25 point decrease in the rate immediately sends the market higher in jubilation because it knows that will stimulate the economy. On the other hand, a 0.25 increase in the rate can send the market down, as it anticipates slow growth. Analysts pore over every word uttered by anyone in the Fed to try and get a clue as to what the Fed will do. 

Different types of interest rates are driven by different forces. Variable interest rates are just what the name says, they vary throughout the life of the loan. The Fed raises or lowers the fed funds rate with its tools.  

Rates on longer-term loans, such as the 15-year and 30-year fixed interest mortgage rate, are fixed for the loan's term, either 15 or 30 years. The same is true for interest rates on non-revolving credit. These are typically consumer loans for automobiles, education and large consumer purchases like furniture. These interest rates are higher than the prime rate but lower than revolving credit. Since these loans are typically one, three, five or 10 years, they vary along with the yields on one-year, five-year, and 10-year Treasury notes.

These interest rates don't follow the fed funds rate at all. Instead, they follow the yields on the 10- or 30-year Treasury Notes. 

These are auctioned by the U.S. Treasury Department to the highest bidder. The yields respond to market demand. If there is a great demand for these notes, then the yields can be low. If there is not much demand, then the yields need to be high to attract investors. 

Until the housing boom in the early 2000s, they varied along with the fed funds rate. That is the target interest rate directly controlled by the As the housing boom accelerated, new types of variable interest rate loans were created. Some varied the rates according to a schedule. The first year was 1 percent or 2 percent, then the rate jumped in the second or third year. Many people planned to sell their home before the interest rate jumped, but some got caught when housing prices started to fall in 2006. 

Even worse was the interest-only loan. Borrowers only paid the interest, and never reduced the principal. The worst was the negative amortization loan. The monthly payment was less than needed to pay off the interest. Instead, the principal on this loan actually increased each month. 

Credit card rates are usually the highest interest rates of all. That's because credit cards require a lot of maintenance since they are part of the revolving credit category. These interest rates are typically several points higher than the Libor rate.