According to the Federal Reserve, the "discount Rate is the interest rate that the Federal Reserve Banks charge depository institutions on overnight loans. It is an administered rate, set by the Federal Reserve Banks, rather than a market rate of interest." Most conventional mortgage rate are determined by the market interest rate for long-term residential mortgage loans. Changes in short-term discount rate may not affect interest rates on long-term mortgages.

"The discount rate is the interest rate for secured overnight borrowing by depository institutions, usually for reserve adjustment purposes." The rate is set by the Boards of Directors of each Federal Reserve Bank. Discount rate changes are also subject to review by the Board of Governors of the Federal Reserve System.

The basic discount rate is adjusted from time to time, in light of changing market conditions, to complement open market operations and to support the general thrust of monetary policy. Changes in the discount rate are made judgmentally rather than automatically and may somewhat lag changes in market rates. "The immediate response of market interest rates to a change in the discount rate -- the announcement effect -- depends partly on the extent to which the change has been anticipated. If rates have adjusted in anticipation of a change in the discount rate, the actual event may have only moderate effects on market conditions." Over time, the discount rate tends to move nearly in line with other short term interest rates.

Accrording to the Federal Home Loan Mortgage Corporation "contract interest rate on commitments for fixed-rate mortgages" are market determined mortgage rates. It represents the long-term end of the interest rate spectrum. Lenders must incorporate into their long-term loan pricing decisions their expectations for future inflation and interest rates. Movements in the mortgage rate also reflect supply-and-demand conditions in the market for mortgage-backed securities. Over time, movements in the primary conventional mortgage rate are highly correlated with movements in other long-term interest rates, like the 10-year constant maturity Treasury bond rate. Both interest rates are shown in Chart 2.

Don't Forget Inflation!
The nominal interest rate (or money interest rate) is the percentage increase in money you pay the lender for the use of the money you borrowed. For instance, imagine that you borrowed $100 from your bank one year ago at 8% interest on your loan. When you repay the loan, you must repay the $100 you borrowed plus $8 in interest-a total of $108.

But the nominal interest rate doesn't take inflation into account. In other words, it is unadjusted for inflation. To continue our scenario, suppose on your way to the bank a newspaper headline caught your eye stating: "Inflation at 5% This Year!" Inflation is a rise in the general price level. A 5% inflation rate means that an average basket of goods you purchased this year is 5% more expensive when compared to last year. This leads to the concept of the real, or inflation-adjusted, interest rate. The real interest rate measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest.. In our earlier example, the lender earned 8% or $8 on the $100 loan. However, because inflation was 5% over the same time period, the lender actually earned only 3% in real purchasing power or $3 on the $100 loan.

Fortunately, the market for U.S. Treasury securities allows a way to estimate both nominal and real interest rates. You can start comparing current real and nominal interest rates by looking at rates on comparable maturity Treasury securities-pick one that is not adjusted for inflation and one that is adjusted for inflation (more about these below). Chart 1 illustrates that there is certainly a difference between the real and nominal interest rates. This difference gives us an idea of the current inflation premium.

Interest Rates in the Business
Advertised interest rates that you may see at banks or other financial service providers are typically nominal interest rates. This means its up to you to estimate how much of the interest rate a bank may pay you on a savings deposit is really an increase in your purchasing power and how much is simply making up for yearly inflation.

Now, let's look at some of the inflation-adjusted securities that provide a real interest rate. The blue line in Chart 1 plotted the inflation-adjusted interest rates paid on these securities over the past several years, In 1997, the U.S. government began offering bonds called Treasury Inflation-Protected Securities (TIPS). Unlike other investments that pay a nominal interest rate, TIPS earn a real interest rate. The TIPS securities earn a fixed rate of interest just like many other types of government bonds. But, in addition to the fixed rate, the principal value of your TIPS bond is adjusted for inflation. So, at maturity, TIPS investors receive an inflation-adjusted principal amount. Also, for the unlikely event of deflation, there is a safeguard built into the TIPS system: the final payment of principal cannot be less than the original par value.

I-bonds, issued by the U.S. Treasury, are another type of investment that earns a real rate of return. Unlike TIPS investors, who receive an adjusted principal value at the end of the investment time period, I-Bond investors receive interest payments that are adjusted for inflation twice each year.

Remember the Rate
Just like with any investment, it is crucial to know the interest rate that you are paying or receiving back from a note loan. Understanding the rate will enable you to compare & analyze it with other perspective investments or loans. You never want to over-pay & of course you always want to sure you are receiving fair market value.