Lord of The Rates Part IV – Consumer Rates

nazgulI’ve reviewed in recent columns what I believe happens when interest rates rise this Summer, in particular what happens to real estate when the FOMC raises the Fed funds rate, Aka “The One Rate To Rule Them All.”

 

“…Nine for consumers doomed to die

One for the Yellen on her dark throne

In the land of FOMC where the money’s born…”

 

While rate hikes generally hurt, I don’t expect this rate hike to change much for consumer interest rates.

Consumers already face a very wide range of interest rates, from 2% Prime auto-loans, to mid-range consumer debt at less than 10%, to the mid-20% for credit card debt, even to stunning 100%+ annual rates for payday loans.

Just as the humans of Middle Earth experienced vastly different Rates of Power, so too do we humans of this Era already face vastly different rates.

I’ll review these different ends of the consumer-borrowing spectrum in turn.

Cheap Prime rates disappear

The very cheapest consumer loans may jump a bit this Summer.

Locking in cheap student loans, mortgages, and auto-loans in this Era left us feeling like the Dúnedain, noble and heroic borrowers.

Credit Unions that offered 1.9% auto loans probably stop doing so immediately following the jump in rates. Historically low rates spurred auto purchases, making us Riders of Rohan, racing across the plain on our fresh swift horses.

In addition, low rates like my 15-year mortgage at 2.75% probably cease being available. In retrospect, those rates will mark a low-tick of the interest rate market.

For a high credit borrower collateralized by a car or home, however, we’re probably only looking at a 1 to 2% jump after rates rise.

Uncollateralized personal loans for high credit borrowers – like you can see on a crowd-sourced lending site like Prosper.com – currently run in the 6 to 8% range. Those rates likely jump a bit as well following the Fed funds hike this Summer.

prosper

Credit cards

Moving a bit higher on the consumer interest rate scale, I doubt credit card rates move much at all.

Your basic credit card rate balance already charges substantially high rates. The national average credit card rate on balances runs around 15% right now, which is high enough to leave your finances feeling as woozy as King Théoden under the influence of Wormtongue.

And that’s just the average. The highest rate you will see quoted nationally is 29.9%, although penalties and fees can push effective rates higher than that. As long as they can limit defaults, banks don’t really need to raise credit card rates above 15% to 29% to stay profitable, when the Fed funds rate rises.

What about those seemingly attractive 0% interest balance transfer requests that come in the mail? Will those go away when rates rise? I doubt it.

0% balance transfers

Credit cards offers to consolidate balances at 0% for 6-12 months probably continue even after rates start to rise, because these aren’t really 0% loans.

In the fine print of most of these so-called 0% offers is the requirement that you pay an upfront 3% ‘consolidation fee’ for the privilege of a supposed 0% balance transfer. When you translate the 3% fee into an annual rate, you get something not at all close to the advertised “0% loan.”

How is this not really a 0% loan, but instead is a nasty trick perpetuated by a Saruman-like wizard, in the service of the Dark Lord? Let me explain.

saruman

If you transfer a high interest $10,000 credit card balance on which you had been paying, say, 18% per year, it is true you would cease having to pay $150 in monthly interest on your balance.

You would instead pay an upfront 3% fee of $300 (on the $10,000 balance in this example). Even if you paid off that loan after six months – before the 0% rate goes away – you’ve already paid an effective 6% annual rate. Credit card banks will happily take that initial 6% rate when they know they’ll most likely have you paying something like the old 18% on the balance, when the six months is over. Since you’re really paying at least 6% rather than 0%, I think banks will find it worth their while to continue those supposed 0% balance transfers.

But that’s not the worst consumer loan ever.

The Nazgûl of Lending

Payday loans – the Nazgûl of consumer lending – obviously can’t go higher from here. These loans, higher than 100% annually, prey from above on the finances of the people below. These are shrieking nails-on-chalkboard black-winged creatures.

Even Yellen in the land of FOMC cannot push these rates higher.

I just looked up a payday lender online and found I could borrow $500 for 30 days, and owe $629.92 at the end of the month. That’s a 315% annual borrowing rate.

The good news? (He said, ironically.) That rate is not going up this Summer, either.

Please Éowyn, or somebody, put a sword through the crown of these undead creatures.

 

Please see related posts

Lord of the Rates Part I – One Rate To Rule Them All

Lord of the Rates Part II – On The FOMC ‘Printing Money’

Lord of the Rates Part III – The Mortgage and Real Estate Market

 

 

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Lord of the Rates, Part I – The One Rate To Rule Them All

Saurons_Eye
One Rate To Rule Them All

Our present Phenomenally Low Interest Rate Era slips quietly into the next.

Interest rates will rise very, very, soon.

We sense the change, but wonder, what does this mean? For many here in Middle Earth, interest rates remain mysterious.

Fortunately, I found an ancient scroll during my sojourns in the Eastern Lands. Many nights, like the Grey Wizard Gandalf himself, I studied Isildur’s ancient texts, and translated that scroll from the Black Speech  of the land of FOMC. I can now reveal the scroll to you, as it explains the mysteries of interest rates. My best translation:

 Three rates for mortgage brokers under the sky

Seven for the bankers in their halls of stone

Nine for consumers doomed to die

One for the Yellen on her dark throne

In the land of FOMC where the money’s born

One rate to rule them all, one rate to find them,

One rate to bring them all and in the darkness bind them

In the land of FOMC where the money’s born.

 

To state a commonly held view1, the Fed funds rate  (aka The One Rate To Rule Them All) goes up in September 2015. Or June 2015, I don’t know, they don’t tell me these secret things anymore. Soon, though.

Ring_of_power
I translated the Black Speech from this Ring I found

Looking back from the future, we will recognize clearly the specialness of this Era, the Phenomenally Low Interest Rate Era.

We will see it as a halcyon time for some, such as prime mortgage and prime auto-loan borrowers.
(I still can’t believe I got a 2.75% 15 year mortgage!)

We will see it as a desert wasteland for people and institutions trying to live off scant bank or bond interest.

But wait, a Hobbit now pulls at my wizard sleeves. “What is an interest rate again?”

hobbit_home
Hobbits wonder: What is an interest rate?

A bridge

An interest rate is a mathematical bridge linking money today to money in the future. Money today is always worth a different amount than money in the future. (This, according to the Wizards’ mysterious spell-chant known as ‘The Time Value of Money.’)

As the near-immortal High Elves of Middle Earth knew, the present ever-slips into the future.

elves_pass_into_the_west
Elves pass into the West, just as money fades into the future

Just as the Elves – sensing the end of their Age – passed wordlessly but inexorably into the West, so too does our money fade imperceptibly but inevitably in value as it slips into the future.

To make up for that loss, the wise ancients decreed that the borrower of money must always provide additional money in the future to the lender.

But how much additional money?

Ah! There you have it. ‘How much additional money?’ is exactly what an interest rate tells us.

If the interest rate is 6%, the borrower owes $6 for every one hundred dollars borrowed for a year. If the interest rate is 18%, the borrower owes $18 for every one hundred dollar borrowed for a year.

Back to Fed funds

Perhaps you’re also wondering, how does the Fed funds rate – aka The One Rate To Rule Them All – actually work?

We start with the fact that US banks are required to hold a certain amount of money, called “reserves,” at the Federal Reserve. Some banks may periodically have too much, or “excess reserves” with the Federal Reserve, while others may periodically have too little.

Banks with too little reserves – presumably temporarily – are allowed to borrow from banks with excess reserves.

The Federal Reserve (Well, a specific board known as the Federal Open Market Committee, made up of regional Federal Reserve Governors) sets a rate at which big banks may borrow that money, for just one day, from each other, using their own reserves held with the Federal Reserve.

A bank that needs money in the short-term – for making new loans, paying its lenders, or returning money to depositors for example – can borrow money overnight from banks that have this surplus sitting with the Federal Reserve.

That specific one-day interest rate – known as the ‘overnight rate’ since the loan from one bank to the other bank lasts ‘overnight’ for just one day – serves as the anchor for all other interest rates in the US dollar economy.

The Fed funds rate, currently set by the committee at a range between 0 and 0.25%, allows large commercial banks to borrow money very, very, cheaply. That cheap bank borrowing in turn fuels very cheap loans to the rest of us in Middle Earth.

Everyone who is not a bank, but who gets a bank loan, will borrow at an interest rate higher than the Fed funds rate, as determined by a combination of their bank and ‘the market’ for loans.

Since your bank can borrow money at 0.25%, it can choose to offer you the chance to borrow money pretty darn cheaply, while still making a profit.

riders_of_rohan
The Riders of Rohan probably floated municipal bonds to raise their army

The dwarves, burrowing in their mountains, borrow cheaply for mining operations. The elves borrow to maintain their palace at Rivendell with attractive home equity lines of credit. Halflings can fill up on ale, on credit, at The Golden Perch or The Green Dragon. The humans of Rohan maintain expensive cavalry regiments through their municipal bonds. Each race responds to the incentives of their particular interest rates. But those are all at rates set by the market. Only the Fed decides, by a small committee, the One Rate To Rule Them All.

If the Fed needs to nudge banks to lend to each other at or near its target rate, the Fed’s trading desk uses a market mechanism called “open market operations.” These are really market-based purchases or sales of bonds to soak up money or release money into the economy.

You could think of the Fed’s open market operations as analogous to the Strategic Petroleum Reserve that the federal government controls, periodically soaking up oil supply or releasing oil supplies, pushing oil prices up or down in the short run.

Something similar happens with the supply of money via bond purchases and sales, when the Fed wants to enforce its Fed funds rate or range.

Like the One Ring of Power, the Fed funds rate interacts with other key ‘Ring Bearers,’ such as mortgage bankers, commercial bankers, and consumer borrowers, each of whom in his own way determines the other interest rates in the economy of Middle Earth. All respond to the inexorable pull of the One Rate To Rule Them All.

 

Please enjoy subsequent (upcoming) nerdfest posts on this “Lord of the Rates” Theme.

LOTR Part II – Does the Fed ‘create money?’ How is Money Born?

LOTR Part III – Mortgage Rates

LOTR Part IV – Consumer Rates

 

Related posts on similar themes:

My 2.75% mortgage, Timing, and I am a Golden God

Fiduciaries: Is It all Unsustainable Right Now?

 

Also, see related video posts

Video: Interest rates are a bridge linking money today to money tomorrow

Video: Interest Rates – Time Value of Money

 

 

 

 

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  1.  Ok, it’s really a Goldman Sachs economist’s view, but we all know who pulls the strings. Haha, kidding. Sort of. Not really.