Interest Rates & the Fed: How it All Works

Nearly everyone shopping for a new home needs a mortgage to go with it.  Consequently, the available interest rates on mortgages has a HUGE influence on real estate sales: people who want to buy are anxious to lock in a low rate, and people who want to sell hope that the low rates will make their property seem more desirable and attainable - certainly, borrowers can afford "more house" the lower rates go, which increases the pool of buyers for your particular property.

But how does this mysterious fluctuating thing happen?  We're about to deep dive into that very concept, so hang on! We're linking together some more extensive articles from the excellent personal finance site The Balance - do click through if you find you'd like more in depth reading.

Most directly, interest rates are set by the banks that lend the money in the first place.  That seems fairly straightforward and intuitive.  They review the credit-worthiness of a particular applicant, and offer loan products (credit card, cash loans, mortgages, secured products like auto loans, etc.) with an interest rate that reflects their findings.  This is why rates vary from lender to lender, and you are very wise to shop around a little!

But how do the banks arrive at their own rates?  This is where the Federal Reserve Bank comes into play, and it's complex.  The Fed doesn't directly dictate what the banks must charge - that wouldn't be open market. Instead, they strongly influence the decisions banks make via policy, and their own lending practices.  The drivers for THOSE decisions come from their own internal reviews of present economic climate factors.  Inflation and unemployment numbers lead the way, although a great many more elements are reviewed.

The Fed is made up of 12 "Reserve Banks" that are genuine brick and mortar places around the country.  They each have a top rep, and those 12 people meet 8 times per year to review conditions, and make interest rate corrections if they feel it would be beneficial.  It's important to understand that keeping interest rates low isn't their objective (although that's the part most of us like best) - their main objective is to control inflation, and make corrections that will help offset recession.  Interest rate adjustment is just one of the tools they use for this economic influence.  (Supervision of the banking industry is also another important role they serve.)

When the Fed determines that they want to lower rates, it buys treasury bonds from individual lending institutions.  This gives banks excess cash reserves. You can see why the Fed is sometimes called "The Banker's Bank!" In turn, the banks look to get that extra cash out to borrowers, because that is how they make money themselves. They often lower rates to entice applicants.

It's a common fallacy that the Fed controls the Prime Rate.  Each bank has their own "best rate" they give their best customers - and they certainly adjust it in direct response to the Fed - but banks themselves determine the Prime Rate.

Even more powerfully than simply influencing US economics, many governments around the world take their lead from whatever moves the Fed makes. Global economics becomes shaped by what those 12 people decide! It is a sobering responsibility for sure!

Finally, here's an infographic from the Federal Reserve Bank in Atlanta, which illustrates the workings of the Fed. If you'd like more information on how rates relate to your real estate needs, give us a ring at Dupuis Team! We are absolutely open and busy during coronavirus isolation, and would love to talk over your own questions relating to real estate, interest rates, and more.