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Interest Rates: The Real Cost of Borrowing

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The basic definition of an interest rate is simply the cost of borrowing money. It’s the cost associated with acquiring credit, whether buying a car, getting a mortgage, or taking a vacation. We encounter interest rates every time we make a monthly credit card or student loan payment. Interest and interest rates are a major part of daily life, yet many people don’t have a good understanding of the most critical types of interest or how their rates are set. Broadening our understanding even a little can help empower us to make more informed decisions, whether at the bank or at the ballot box.

interest rates cost borrowing

Federal Funds Rate

Commercial banks are required to keep a certain amount of liquid reserves, like cash, on hand in case of a bank run. Each bank must meet the minimum reserve requirement, which might require the bank to borrow from another one. Other banks may have excess reserves, which they’re free to loan out to other firms. At any one time, there are usually institutions in need of reserves and others willing to loan to them, but, of course, with interest.

The interest rate charged for such inter-bank lending depends on several factors, including how much money is available in the market, current interest rates, and length of the loan (usually overnight). The Federal Reserve sets a target interest rate for inter-banking lending called the federal funds rate. By changing the federal funds rate, along with other open market operations, the Fed tries to influence the money supply throughout the entire system, usually to stimulate economic growth and/or manage inflation.

If interest rates are high, banks are more likely to make sure they have required reserves on hand, thus avoiding the need to borrow. Ensuring reserves usually means lending out less to customers. Less lending means less money within the economy. Therefore, raising the federal funds rate (or “tightening”) usually creates a contraction of the money supply, while a lowering (or “loosening”) means an expansion.

The federal funds rate is a key interest rate that eventually impacts, among other things, what interest you pay on your home, car, or credit card.

Federal Discount Rate

Of course, there are times when there are too many banks needing loans than can provide them. If a depository institution needs to meet its reserve requirements, but can’t find a loan, it can get one from the Fed who acts as a lender of last resort. The process is known as “discount window” lending, and the interest on the loan is called the federal discount rate. Like the federal funds rate, changes in the discount rate can affect the monetary supply.

The board of directors of each reserve bank sets the discount rate every 14 days. Most loans by the Fed to depository institutions are meant to be overnight or short-term. However, the discount rates have changed significantly during national emergencies like 9/11 or the 2007-2009 “Credit Crunch”. For example, during the initial phase of the Crunch, the Board of Governors cut the discount rate by 50 basis points (from 6.25% to 5.75%), while loan terms were extended from overnight to up to thirty days. The Fed’s intention was to keep banks solvent and liquidity alive throughout the economy.

Prime Interest Rate

Both the federal funds rate and the discount rate apply to lending institutions, but what about the interest the average consumer pays? The prime interest rate (or prime lending) rate is an important index used by banks to set rates for many consumer-type loans, such as for automobiles or credit card purchases.

The prime interest rate is indexed from some of the largest banks and reflects the interest charged to their favorite customers (i.e. corporations). The most recognized index comes from The Wall Street Journal, which surveys 30 of the largest banks and publishes the consensus prime rate. Typically, the prime rate runs around 3% above the federal funds rate. The prime rate usually moves up or down with any changes in the federal funds rate.

Many credit cards, adjustable rate mortgages, and variable short term loans use the prime rate to determine their total interest. For credit cards, the rate is usually listed as the prime rate + another percentage rate for various fees (ex: 3.5% + 12% = 15.5%) The interest rate above the prime rate is known as the “spread.”

Beginning at the top with the federal funds rate, it’s easy to see how the Fed’s monetary policies trickle down the financial system to ultimately affect how much we pay for everyday things.

The Fed’s Real Interest

It’s important to note that the various interest rates and processes described have been carefully set up to artificially control rates and the money supply. That is, there also exists the “real” interest rate, which, if left undisturbed, would be determined by the free market at any given time. In fact, what the Fed does when it changes interest rates is currency manipulation.

Much like prices, financial markets are quite capable of determining the interest rates through competition. Interference with that process has many unintended negative consequences to the economy. When the Fed lowers rates to almost 0%, those who save are punished while those who borrow are rewarded. Our service economy and consumer culture support such a policy, but an economy that’s overly-leverage, consumer dependent, and running trillion dollar national debts can’t afford to spend its way out of a recession. Saving for future investment is what’s needed, yet misguided monetary policy demands the other.

What’s worse, the Fed’s own low-interest policies have created an impossible predicament where it’s impossible to raise rates. Peter Schiff explains:

“The Federal Reserve has worked itself into the uncomfortable position of being between a rock and a hard place. If it continues its policy of economic stimulation by increasing inflation, we risk hyperinflation and eventual collapse. If it raises interest rates to bring inflation down, protect the dollar, and preserve foreign investment, it will cause deepening recession in a nation overextended with personal and government debt … As a result, significantly higher interest rates would result in meaningful drains on our national income. Furthermore, as the outstanding debt is now very short-term, higher rates will affect the total of what the government owes, not merely new borrowing. In other words, American taxpayers have been committed to the mother of all adjustable rate mortgages!”

Even though the Fed’s low-interest rates may be creating the ultimate American bubble, this doesn’t mean you can’t isolate your wealth from the collateral damage. Economic and political instability throughout the world is driving many investors to buy gold and silver as a safe haven.

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