Why Rates Go Up Or Down

There has been a lot of talk in the media about the effects of rising interest rates and what they will do the economy.  Some say it is a sign of growth, others say it will harm growth and kill the middle income Canadian family.  Let's start off with some basic facts about interest rates:

Interest is the cost of borrowing or the return for lending money, depending on if you are the borrower or the lender.  The rates at which lenders are willing to lend at are determined by risk, lending competition, and the desired rate of return.  The general rates at which borrowers borrow money at are determined by almost the same things; risk, lending competition, and the forecast rate of return.

Risk -  If risk is considered high, than rates increase.  There is a lot that goes into high level risk assessment some of them working against or with each other: the state of the economy (federal and international), inflation, Central Bank intervention, and the supply and demand for money.

• If an economy looks to be risky or declining, rates go up, and if it looks good rates go down.
•  Inflation is the rate of increasing or decreasing cost for goods and services.  If inflation is rising, rates go up as those who lend money want to keep their returns above the inflation rate.  If inflation decreases or is stable, rates will relax as lenders are less afraid of losing money due to inflation.
• Central Banks often try to have a target level of inflation, hoping to keep it low and stable so that people aren't afraid to invest in companies, equipment and technology.  Central Banks control overnight rates at which they lend money to major financial institutions, thus influencing the cost of money that the banks use.  Usually increases or decreases by the Central Banks are eventually passed on to consumers and commercial borrowers.
• If there is high demand for money, the money supply tightens and the rates go up.  If there is low demand or there is a lot of supply, the rates go down.

Lending Competition - There are a variety of organizations looking to lend people and businesses money.  The most well know are banks and credit unions which traditionally lend out money that has been deposited with them and is protected by some form of deposit insurance.  The depositors get paid interest, or a return, and the banks get paid interest by those who borrow from them.  Because each bank or credit union has similar costs of deposits and technology, their rates are usually quite competitive with each other.  They are also directly impacted by rate changes at the Central Bank, so their rates often adjust up or down in a similar time frame.  There are some slight differences based on the individual needs of each organization, but the rates are usually very similar to each other, leaving their service levels as the main differentiator between them.

Rate of Return - The rate of return is what a lender receives from a borrower for the use of his or her money.  If the risk of not being paid back for the loan increases, than the expected rate of return increases as well.  If a loan is secured with something of value, like a mortgage is a loan secured by land and buildings, then the risk of loss decreases to the lender and the expected rate of return.  Inflation is a risk that the value of something may decrease over time, so loans made over longer periods of time tend to have higher rates than those over a one year period to make up for the possible decrease in value of the money leant out.

So, those are the basics about why rates go up or down.  The next post will be about the impact of the upcoming rate increases.  Jerry