I’ve been curious as to the effect that rising interest rates will have on the U.S. From what i know of economics, i see a disaster looming. Here are some points i’ve been pondering:
Many people have been buying homes, or refinancing their current mortgages (either to get better deals or to get some money to make home improvements) with fixed rate mortgages. When interest rates rise, won’t these loans be a huge burden? When interest rates rise high enough, and banks start losing money on these loans, won’t this be a huge burden to their business? Or are these loans such a small percentage of their income that it will only make a minor dent in their overall profit? And if it is a huge loss for the banks, how will they survive, will there have to be a huge government bailout?
The deficit is at record levels. From what i’ve heard of Bush’s plan, he wants to cut the deficit in half in four years. This means we will have an enormous deficit for 4 years, then only a huge deficit thereafter. From what i know, the deficit is paid for by selling U.S. Securities (bonds and such). By the phenonenom of supply and demand, an increase in bonds will mean that the price of bonds will drop, meaning that they will have to offer a higher interest rate for the bonds. Will the rise in interest rates on U.S. Securities have a major impact on national interest rates? Or, are U.S. Securities such an insignificant part of overall securities that there will be little impact on interest rates?
Interest rates have some effect on the stock market. The market will do better with lower interest rates. In the past year, the Dow Jones has bounced back. It again passed the 10,000 mark, and approached previous levels, close to 11,000. But this is all on the back of record-low interest rates. Now, with even the threat of higher interest rates, the market has started falling again, below 10,000 just the other day. When interest rates start rising, will the stock market be able to handle it? Are we looking at a sharp decline in the future? Is stock market performance related to the actual interest rate or the change in interest rates? Or both?
How much control does Greenspan actually have over interest rates? Is he partisan, does he favor one administration over another? Has he been keeping interest rates artificially low over the past year? If he has, although good for the short term, will it be disastrous in the long term?
It’s not possible to discuss interest rates without discussing inflation, those two factors depend on each other. The recent warning from Greenspan about an increase in the interest rate is to counter rising inflation.
The biggest effect from higher interest rates is that companies has to pay more on their loans, something that would hurt investments and take away money to employ people. Production cost more. Also, consumers will buy less when they have to use more money to pay their loans. Further, increased inflation hurts the export business because domestic products become more expensive abroad, thus harder to sell. However, higher interest rates also attracts more foreign capital, which usually is a good thing.
In general, loans will become more of a burden, both to average income families, and to banks. But more important, when interest rates rise, people buy less homes. If interest rates rise a lot, the price of real estate goes down. If that happens families will have to provide extra security on their loans. If they have to sell they could still owe money after the sale.
Over here we had a 15% interest rate in the late eighties. The real estate market plummeted and almost every bank had to be bailed out by the state. I knew a girl who had a $150.000 apartment which she had to sell. She still owed the bank $40.000 after the sale.
Normally, the bigger the deficit, the higher the interest rate must be to sell the bonds. The problem develops as the government has to substitute old low interest bonds with new bonds carrying a higher interest rate. The government then has to use an increasingly bigger portions of its budget to pay for its loans. When the government cannot offer a high enough interest on bonds, foreign capital will begin to disappear.
A huge deficit is the Big Bad Boy in national economics, no matter what spin the current administration puts on it. According to the tale, Nixon became deeply worried when the deficit in his time hit 0,5%. The idea that deficits doesn’t hurt the economy is just mumbo-jumbo. It’s an entirely new idea, widely unsupported everywhere pre-1980, and still unsupported in Europe and Asia today.
In my opinion, US bonds and the american technology advantage are the two things that keep the american economy floating. Though I could be very wrong, there’s just no definite answer in economics.
Well, expectations play a big role on the stock market. It’s inter-connected, but in general the stock market will move slowly or decline with rising interest rates. But only a slight increase in the interest rate shouldn’t affect the stock market much. It’s still about sales.
US dopers should be able to give you an indepth answer to this. My opinion is that Greenspan is non-political, and that he can do more or less what he sees fit to keep the market going. Personally I think the interest rate has been kept too low for a while, because if anything bad had happened he wouldn’t have had the ability to go further down to get the economy going again. On the other hand, I suspect there are good reasons why he is the boss and I will never be.
Greenspan is regarded as being largely a-political in his handling of rates regardless of what his personal political leanings might well be. My impression was always that he was going to fulfill his obligations to the country and screw whether it hurt the politicians. His goal appears to have been stability and the minimizing of whatever instabilities occured.
That said, rising interest rates would hurt quite a bit if they rose sharply. It would make borrowing of any sort more expensive and therefore put pressure on consumers not to buy that house, car or other big ticket item. The same applies to businesses, of course. Could the justify borrowing for expansion when the cost of the borrowing goes up too high? Maybe…maybe not.
As far as homeowners go…I’d bet (but don’t know) that a lot of the recent refinancing boom locked in their rates. My own case, for example: I recently got a mortgage for 6% fixed. Simple enough. If interest rates fluctuate it won’t effect that note in the slightest (barring disaster and societal collapse)(woo!). Those on adjustable rate mortgages, however, will be screwed. I’ve been down that path in my first house. Never again.
I (mis)quote PJ O’Rourke: “We’ve all got our mortgages locked at 5%. We’re ready for 20% rates on T-Bills!”
Where an increase in interest will harm housing is in new home purchases and construction. If suddenly mortgage rates were 10% we’d see a precipitous drop in both home sales and new home construction. And that would hurt the overall economy fairly sharply.
Some banks may indeed lose some money in the overall cycle if they haven’t been running a tight ship.
But in general the banks will not lose money.
Refinancing works pretty well for the bank.
Say you take out an $80,000 loan at 8.5% (30 yr). After paying off $20,000 you see that interest rates are now 7.75% and you would like to take advantage of the lower rate. So, you go in to refinance.
You owe $60,000, you refinance it getting a new 7.75% loan, and decide to change the term to 20 years (some banks however require you to take out another loan for an equivalent term, which really cuts in to any profits you might make). This works out to you paying $93,000 back to the bank for that $60,000. Add the $20,000 you’ve already paid back and the bank makes out with $113,000 for loaning out $80,000. That in itself is still a significant profit (they get back $204,000 with the old rate.)
But then in comes the X factor. Prepayment penalties and refinancing charges. Typically refinancing charges cost around 6% of the remaining principle. So in this example they would be about $3600. Then, prepayment penalties, that is right, most mortgages have a little clause in them that if you pay them off too early you have to pay penalties. If you just pay a little bit more each month it usually isn’t a big deal. But when you refinance, you are paying off the entirety of your mortgage all at once. So that can result in an extremely nasty prepayment charge, and there’s typically no way out of those.
The bank might make out with up to $140,000 total in the deal, so yeah, the bank doesn’t make as much as they originally would, but it isn’t that bad for them, either.
The reason they do it is, the prepayment penalties and the refinancing fees are “badda bang” instant profit that otherwise wouldn’t have been coming in from you. In the long term they don’t make as much but, then again with the quick profit they’ve made from you they will be able to offer out more loans than they otherwise could have, so their overall business is up.
Banks basically make money in this very simple way.
To break it down very simple, there are two types of accounts, loans they’ve taken out from people like me and you in the form of savings accounts (and a plethora of other accounts I won’t get in to for simplicity’s sake) and loans they make out to people.
We earn interest on our “loan” to the bank. But it is a pittance compared to the interest rates on the money they loan out to others. When the interest rate of a loan falls down to 4%, the interest rate on a savings account also falls down considerably. So they will be making money throughout this time.
Then of course when rates go back up… well, the interest rates on the loan stay the same (unless someone is dumb enough to refinance at a higher rate), but the savings accounts have their rates increase. That creates somewhat of a problem, but here is how the banks rationalize it.
Lower interest rates means overall more loans they can make, the volume of their business is higher. Just like in a grocery store, if you can sell 500 apples at $0.50 and 215 apples at $1.00, you sell the apples at $0.50. They get a lot of income coming in from the loan processing fees et cetra that represents instant gratification income. They can use that income to open yet more loans.
Typically people buy more than they save. So banks are usually making a lot more money each month from interest owed to them on loans than they are spending on savings accounts.
And overall the loan fluctuations aren’t that bad for the bank. Even when they go rock bottom low to sky high the banks are still coming out on top.
Plus we aren’t even factoring all the other profits a bank might make. You’d be surprised how significant fees related to checking accounts and other financial services equal to, typically more than enough to cover anything they might lose lending.
You have a misunderstanding of what the deficit is, I think.
The U.S. Federal budget is the budget for the federal government of the United States. It is a spending plan for the government, it works on projected income, and tallies up expenses. It’s just like accounting 101 if you’ve ever taken it, just on a much, much larger scale.
A budget deficit exists when expenses exceed income.
That has been the case for a few years now with the United States government. What happens when spending exceeds income? Well, the U.S. government can either say, “well out of money, we’ll wait until next year to get the money for this project” which virtually never happens, or we can go into debt, which virtually always happens.
In fact we’ve gone in to debt so much over the past century that we are a debtor nation, our country hasn’t been free of national debt in a very very long time.
The national DEBT is created when the government offers bonds, when you buy a bond, you are actually loaning the government money at a set interest rate (and the government needs to borrow the money to cover up the shortfall between income and spending). The U.S. government can also of course borrow money from banks, domestic and foreign, but a surprisingly large percentage of the U.S. debt is actually owed to individuals buying bonds.
The deficit isn’t “paid for” by selling bonds. The deficit isn’t paid for at all, because it isn’t an “entity” like the national debt is. The deficit is simply red ink on the budget. The deficit can be destroyed instantly and completely simply by lowering spending below income. Creating a budget surplus. However, the debt created from the years of deficit spending does not go away just like that, we have to continue paying it off, paying off the interest on the debt et cetra.
Bush doesn’t have to take out more loans (bonds) to lower the deficit, all that does is increase the national debt. All he has to do is lower spending, and I’ve heard him say that in 10 years, the deficit spending he started will be adjusted, and the budget balanced again. And he then explains that the current deficit spending is necessary because of pressing global affairs. Maybe he does plan on either lowering spending or increasing our income (which means taxes, btw), but I don’t know what he really has in mind.
Again, without getting in to too much detail, typically as long as the rates change upwards over a long period of time the effect is not that bad. The market can handle it and has handled interest rate increases in the past.
He has pretty much direct control over bank’s interest rates.
The Fed can regulate how much of a bank’s money has to be kept in reserve obviously a bank that has $15m in savings in it does not keep $15m in savings in the bank at all times, it loans a lot of it out, typically around 90% of it out. The % the bank must keep on hand is regulated by Greenspan and the Fed. When the % is lower (like 5%) then the banks can loan out more money. The more it can loan, the lower it will set interest rates, because of the standard increased volume = decreased price per purchase on any given product.
Also, the Fed can set it’s interest rate on loans it makes to banks (the Federal Reserve makes many loans out to lesser banks), if the Fed’s rates are high, the banks are paying out the nose, and they make YOU consequently pay out the nose so they don’t lose money.
The Federal Reserve has many very powerful tools. But is all a balancing act.
If the interest rates are too high, spending goes down and we have recession. Too low, for too long and we suffer bad inflation, which creates its own economic problems, it is all a balancing act for the Fed.
If history is any judge, one thing that will happen is the same people who are trashing stocks right now because of “fears or a rate hike” will be buying stocks like crazy because “Greespan is serious about fighting inflation”.
It will be a burden, but if the interest hike isn’t too big it won’t be a huge burden. For it will hurt the banks due to less real estate activity, and probably a lower margin on their money as other have mentioned, but a lot of them won’t lose money on the loans, because they don’t keep the loans, but package them up and resell them.
So the poor schmucks, much like you and I, who buy these repackaged securities will be the ones losing, or at least getting a suboptimal rate, on them.
