How Interest Rates are Determined (4/26/05)

There are many different types of interest rates. I'll address the ones that are most common: Credit cards, Car/Boat loans, and mortgage rates. Feel free to skip a section if it's not relevant to you.

Before I go into those individual categories, I'll enlighten you a little on how rates tend to go up or down "in general". The Federal Banking System is governed by the Federal Reserve Board. The head of the Federal Reserve Board is Alan Greenspan. Many economists call him the 2nd most powerful man in the country (don't tell Dick Chaney). He controls monetary policy in the United States which makes a great impact on our economy. There are several different factors that go into the boards' decisions. Among them are the inflation report, unemployment report, consumer spending report, etc. The board meets periodically, and among their many duties in regulating national banks, they will typically make a decision regarding a key federal interest rate. The rate they control is called the Federal Discount Rate. This is the rate the Federal Reserve Bank charges member banks to borrow money.

When they raise this key interest rate, everyone, including credit card companies and member banks will follow suit. The rate that banks charge for floating credit facilities is called the Prime Rate. This is most likely something you've heard of. Don't be mistaken: The Federal Reserve Board does not control the Prime Rate, but their decision regarding the Federal Discount Rate will influence the decision banks make regarding the Prime Rate. The Prime rate today is 5.75% (April 2005).

Credit Cards
Credit Cards are typically referred to as floating rate credit facilities. This means the rate is typically tied to the Prime Rate with a margin. The vast majority of credit card rates are somewhere between Prime + 0% and Prime + 5%. This is sometimes determined by your credit score. The better your credit score is, the better your rate will be. Your statement will have your rate printed on it in bold letters. So, if your rate is 7.75%, then you know your rate is most likely Prime + 2%. This is a good rate. After all, credit cards are considered high risk to banks since they are not secured (no collateral). A lower rate of Prime + 0% is typically reserved for people with very good credit or they may have a significant fiduciary relationship with the bank. Most importantly, when the Federal Reserve Board raises the discount rate, the rate on your credit card will go up as well almost 99% of the time.

Now, some credit card companies have introductory rates. These are typically a fixed rate for so many months. Be sure to find out what the rate will be once the the introductory period ends. Credit card companies, such as Capital One or MBNA America typically have lower rates than banks. Shop around if rate is one of your primary concerns.

Several companies will reserve the right to raise your rate upon a late payment (this policy is usually buried in the fine print on the back of your statement). Sometimes, they'll raise it as high as 20%. If this happens to you, I highly recommend that you transfer your balances to another card as soon as possible. Credit card companies are pretty strict and are not likely to lower your rate once this happens, no matter what your sob story is. There are plenty of other credit card companies eager to gain your business. You may even find a great introductory rate if you're willing to transfer your balances.

Car/Boat Loans
These loans are typically referred to as installment loans because they have a level payment that's made monthly until the loan is paid off. Again, in some cases, these rates are also determined by the borrower's credit score. Higher credit score, lower rate (you know the drill by now). New car rates are lower than used car rates because the collateral is in better shape and the loan is considered lower risk.
All car rates are typically determined by four factors:
1. New or used car
2. Credit score
3. Term of loan (how many months)
4. Amount of loan

For example, if you want to borrow $20,000 for a new car over six years, the rate will be about 6.15%. This same loan over three years is 6.25%. The rate is usually lower for longer terms since the bank is making more money from the deal for a longer period of time. Most of these loans do not have a pre-payment penalty (meaning you can pay them off early without a penalty). Therefore, if you want the shorter term, simply get a loan for the longer term with the lower rate and make additional principal payments to pay it off early.

Banks typically can not compete with dealers on car loan rates. The dealers are much more willing to go lower on the rate if they know they're going to make a sale. I know some people hate to haggle with the dealership, but it can save you money if they know you're going to walk over a small break on the interest rate. If you're buying a new car, there may be a special offer, such as 0% financing for 36 months (or something like that). If this is available, take it.

If you're borrowing a small amount of money for a used car, don't get too stressed about the rate. The payment will not be effected that much by the rate. For example: If you borrow $10,000 over three years, the payment at 6% is $304 and the payment at 7% is $308. Some people shop around rates for days, only to find out it saves them a couple of bucks a month. The difference in this particular example is a savings of $144 over three years.

If you're going to purchase a car, I suggest you go to your bank first and obtain their published rates and work out some possible payment scenarios. Some banks give discounts to their customers on installment loans. Once you're armed with what your bank can offer, see what the dealership can offer while you're shopping for a car. Don't lie to the dealership in order to get a better rate. Dealers have very close relationships with banks and they will know if you're lying.

Car salesman have a negotiation tactic to be aware of: "What kind of payment are you looking for?" This is a clear red flag if a salesman asks you this. They figure, if you get the monthly payment you ask for, he can screw you on the cost of the car and the rate. Sure, you can get a brand new $35,000 Lexus for $450 a month. But the dealership would charge you 8% interest over nine years in this scenario. Always look at the details of the transaction before signing on the bottom line. At $450 a month for nine years, that $35,000 Lexus will cost you a total of over $49,000. Financing a car is expensive, so put down some cash if you have it. Otherwise, most dealerships and banks are willing to finance 100% of the purchase.

Mortgage Rates
As you probably know, these are very competitive. Shop around and shop as often if you wish.
Mortgage rates are based on three primary factors:
1. Mortgage Type
2. Type of property (primary residence, investment property, vacation home, etc).
3. Amount of loan

There are several different types of mortgage loan products. Here are the most common:
1. 30-year fixed rate - Rate stays fixed for 30 years.
2. 15-year fixed rate - Same as 30 year fixed, but for 15 years.
3. ARM (Adjustable Rate Mortgage). This loan has a fixed rate period, this can adjust every year following that fixed rate period. For example, a 5/1 ARM mortgage will stay fixed for 5 years, then changes each year after that based on a set margin and index.
4. Interest only - Payment is interest only without reduction in principal.

The longer the fixed rate period, the higher the interest rate. This is because the bank is taking on more risk based on the volatility of the market over a longer term. Therefore, a 30-year fixed rate loan is higher than a 5/1 ARM. All rates can fluctuate on a daily basis and don't necessarily influence each other. Daily rate sheets are printed by most banks or you can find rates online or in the newspaper.

Since rates tend to fluctuate, it's very crucial to "lock in" a rate when you want to refinance or sign a contract to purchase a house. Most mortgage companies have some sort of "float down" period. This means, if the rate drops after to lock in your rate, they will lower your rate to meet the current rate. They won't volunteer to do this for you, so make sure you're aware of the provision (if one exists) and hold them to it.

The primary thing to be aware of when obtaining a mortgage is the fees involved. Beware of a broker. They sell their loans once you close so they make their money primarily on fees. Some banks sell their loans too, but typically won't screw you on the fees like a broker will do. Most of the fees I'm referring to are very common. They are the appraisal, title insurance, recording fees, credit report, etc. These are fees that everyone charges and they should be fairly similar across the board. The fees to look out for are the fees the mortgage company charges to process the loan. This is typically referred to as one of the following: a loan processing fee, underwriting fee, broker fee, or funding fee, etc. This is the fee you need to watch out for. No one should be charging you $1,000 to do a mortgage for you. If this fee is greater than $500, you're being robbed. All lenders are required by law to send you initial mortgage disclosures within three days of your application. Do yourself a favor and look over these, especially the document titled "Good Faith Estimate". This document has a breakdown of all the probable fees.

I won't go into all the details about mortgages and mortgage rates. There are so many different scenarios and I may bore you with all of them. Feel free to call me and I can take a look at your specific situation and address your specific questions. I can even go over your mortgage disclosures with you and let you know if you're getting a good deal.