Discount Rate Information

What is the relationship between the Discount rate and Mortgage rates?

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 rates are determined by the market interest rate for long-term residential mortgage loans. Changes in the short-term discount rate may not impact 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, considering 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.

According to the Federal Home Loan Mortgage Corporation, the “contract interest rate on commitments for fixed-rate mortgages” represents market-determined mortgage rates. It signifies the long-term end of the interest rate spectrum. Lenders must factor 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.

This relationship between discount and mortgage rates is interconnected through factors like inflation and liquidity closely tied to long-term securities. However, short-term and long-term interest rates may deviate from their typical pattern due to factors like monetary policy and anticipated inflation. During these periods, the yield curve is sloping downward, and short-term interest rates are higher than long-term rates. & &

What is the difference between the real interest rate and the nominal interest rate?

Don’t Forget Inflation!

The nominal interest rate, also known as the money interest rate, represents the percentage increase in money paid to the lender for borrowing a certain amount of money. For example, if you borrowed $100 from your bank a year ago with an 8% interest rate, when repaying the loan, you’d need to pay back the $100 borrowed plus $8 in interest, totaling $108.

However, the nominal interest rate does not consider inflation, remaining unadjusted for it. To illustrate, if you see a headline stating “Inflation at 5% This Year!” on your way to the bank, it means the general price level has risen by 5%. The real, or inflation-adjusted, interest rate takes this into account, measuring the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest. In the example, although the lender earned 8% or $8 on the $100 loan, the 5% inflation meant the real purchasing power increase was only 3%, equating to $3 on the $100 loan.

The U.S. Treasury securities market provides a way to estimate both nominal and real interest rates. Comparing current real and nominal interest rates involves looking at rates on comparable maturity Treasury securities, considering those not adjusted for inflation and those adjusted for inflation. The difference between real and nominal interest rates gives an idea of the current inflation premium.

Advertised interest rates, typically seen at banks, are nominal interest rates. It’s up to individuals to estimate how much of the interest rate a bank pays on a savings deposit truly increases their purchasing power and how much compensates for yearly inflation.

Inflation-adjusted securities, such as Treasury Inflation-Protected Securities (TIPS), provide a real interest rate. TIPS earn a fixed rate of interest, and their principal value is adjusted for inflation. Additionally, I-bonds, issued by the U.S. Treasury, offer investors interest payments adjusted for inflation twice each year.

Understanding the interest rate is crucial for any investment or loan, allowing for comparison and analysis with other potential investments or loans, ensuring fair market value and preventing overpayment.