How Interest Rates Affect the People - Essay Example

How Interest Rates Affect the People Introduction The economic systems that govern us as a people are quite complex and often become difficult to understand since there are quite a few variables involved in how changes in the economy affects the average person. However, there is one variable which has a direct impact on almost everything that may be present in a given economy and that is the interest rate (Weaver, 2007). Even the slightest change in that percentage value for an economy like America or the European Union can have far reaching affects on not only the economy of the region but of the entire globe as well if we take the links between international economies into consideration (Epping, 2001). The Interest of the People in Interest Rates Recently, an article was presented in the media by the Austin-American Statesman which is a part of the COX Newspapers group. The title of the Article was ‘Nasty surprise may await homeowners with adjustable mortgages’ and it was written by Susan Tompur. Basically, the article discusses how rising interest rates could negatively affect homeowners who have adjustable rate mortgages. If their interest rates rise high enough, they may not be able to make payments on their mortgages which could lead to a situation of foreclosures or for them seeking cheaper housing options. While the article considers the situation in a rather simplified manner, the real connection between interest rates and the housing market is quite complex since the setting of the interest rate is dependant on several things such as the monetary policies of the government and the direction of the economy. On the other hand, the housing market itself depends strongly on supply and demand as well as the relation to mortgage interest rates or housing finance products which are created by banks or offered by other lending associations that deal with the housing market. In fact, there are several factors that affect the rise and fall of mortgage rates around the country since regional demand can also have a substantial affect on housing prices but the overall shape of the interest rates for mortgages depends on the federal interest rates set by the Federal Reserve. In terms of the long term mortgage rates i.e., 15 and 30 year mortgage rates, ever since 2001 the rates have remained close to the interest rates set by the Feds. The directional connection between the two is certainly present therefore an understanding of the federal interest rate is important to obtain an understanding of the housing market and the affect it has on the people. Simply put, the federal interest rate (the fed rate) is the rate of interest at which depository institutes loan out their holdings in the Federal Reserve to other depository institutes on an overnight basis (Arnold, 2005). This rate is different from the discounted rate which the Federal Reserve uses to calculate their loan payments to other financial institutions such as insurance companies or commercial banks. The rate has a significant impact on economic growth along with the creation of employment depending on several factors in the monetary policy being followed by the country. The rate is controlled by the Federal Reserve System which operates to ensure that all American banks keep a certain level of reserves which are ideally a percentage value of the bank’s current demand accounts (Arnold, 2005). Since this is presented as a regulatory requirement for banks to do business, some banks may borrow money from other banks to maintain such a level of reserves and the interest rate paid between banks would be based on the Federal Rate. Through this method, the Federal Reserve has considerable power over the supply and demand for balances of the Reserve Banks. Ideally, the monetary experts at the Federal Reserve are there to ensure that the rate is set at a level that it will stimulate economic growth or bring stability in the economy depending on what is needed by the country. However, the economic demands have to be balanced with political or social realties which may also influence how and at what level the rate is to be set. The Fed Reserve therefore adjusts the rate from time to time to keep the economy running efficiently. This is because even a slight change or even an expectation of change creates questions for the economic experts who have to reanalyze their estimates for the future of the economy (Wikipedia, 2006). If we create a correlation between the Fed rates to the housing starts over a period of time, it can be seen that there is a connection between the two. For example, during 2002 and 2004, the fed rate remained relatively stable and at the same time, the housing startups remained relatively flat with seasonal ups and downs. This is because the fed rate indirectly affects the mortgage rates and that indirectly affects the building and purchase of houses. However, since there are two indirect links, the fed rate has a muted but still visible effect on the housing markets (HUD, 2006). The indirect link comes from the nature of the Fed Rate since it is thought to be a short term rate. As a short term rate, it pressures long term lending rates up or down and these are linked to treasury bills, consumer loans as well as mortgages (Luedeman, 2006). Expectations of the long term loan rates are usually not as highly variable because the fed rate adjustment happens several times over the life of a loan such as a mortgage. On the other hand, continual downward adjustments of the short term fed rate could certainly bring down the interest rates for all long term contracts (Federal Reserve, 2006). Once long term rates have gone upwards or downwards, significant changes can be expected in the level of stock markets since investing in stocks may become more feasible especially if the interest rates are too low to attract investors (Poole, 1998). If interest rates provided by banks are high, then people may invest with the more secure option of putting money in banks rather than risk their money in stocks. The interest rate therefore also guides investment towards the stock market or into private businesses and this can help the economy if such measures are deemed necessary by the government’s economic experts. As discussed in the article, signs of coming changes to interest rates, or the news of lowering of interest rates will signal to all monetary investors that the Federal Reserve expects the economy to gain in strength in the future and this will impact all equity prices towards higher ground. If the economy is showing signs of weakness or a slowdown, the Federal Reserve may reduce the requirements for reserves or interest rates for a loan to help businesses and increase the overall demand for goods and services in the economy. Thus it will become cheaper for people to build and buy houses thus allowing more individuals to take mortgages. Conclusion In conclusion, the American public and more importantly, the homeowners are certainly affected by changes in the interest rates and while lowering the interest rate could be beneficial for them since they could have more disposable income it needs to be balanced with the need for the economy not to be over heated. This is a delicate balance which needs to be maintained by the government and government supported bodies since the economic systems which are connected to changes in the interest rates need to be guided correctly. Word Count: 1,377 Works Cited Arnold, R. (2005) Economics. South-Western Publishing. Department of Housing and Urban Development (HUD). (2006). Buying a Home. hud.gov website: http://www.hud.gov/buying/index.cfm Epping, C. (2001). A Beginner’s Guide to the World Economy. Vintage Books, Federal Reserve. (2006). The Federal Reserve System: Purposes and Functions. Federal Reserve website: http://www.federalreserve.gov/pf/pf.htm Luedeman, K. (2006). If the Fed raises rates - what does it mean for mortgage rates? from Goodmortgage.com website: http://www.goodmortgage.com/News/2006/special_fed_rate_increases.htm Poole, W. (1998). Economic Growth: Is the Fed Irrelevant? Federal Reserve Bank of St. Louis website: http://stlouisfed.org/news/speeches/1998/07_15_98.html Tompur, S. (2007). Nasty surprise may await homeowners with adjustable mortgages. Austin-American Statesman Website: http://www.statesman.com/business/content/business/stories/personalfinance/06/24/24mortgage.html Weaver, F. (2007). Economic Literacy. Rowman & Littlefield. Wikipedia. (2006). Federal Reserve. wikipeida.org website: http://en.wikipedia.org/wiki/Federal_Reserve Read More