The curious case of today's bank rates
April 17, 2013
Bank rates are uncommonly low, but that's not the only unusual thing about interest rates these days. To a large extent, the normal relationship between time and interest rates has broken down.
Under normal circumstances, interest rates get higher the longer the commitment is. Whether it is a certificate of deposit or a mortgage, whoever is receiving the money would normally pay a higher interest rate in exchange for not having to repay the money for a longer period of time. However, this premium for longer commitments has been almost completely erased in recent years.
In part, this is due to the Federal Reserve's aggressive tactics to stimulate the economy. Normally, the Fed would adjust short-term interest rates as needed, while letting long-term rates float according to market forces. However, the Fed's quantitative easing policies in recent years have included regular purchases of long-term bonds and mortgage-backed securities in an attempt to skew those markets toward lower long-term interest rates.
The current environment has created a few anomalies that may affect how people make financial decisions. Here are three examples:
- Long-term CD rates are unrewarding. Historically, you could be rewarded for locking into a long-term CD by getting significantly higher CD rates. With long rates steadily coming down while short rates are already near zero, this reward has diminished in recent years. The Federal Reserve publishes historical data on one-month, three-month, and six-month CD rates going back to the mid-1960s. Historically, 6-month CDs have yielded an average of 24 basis points more than 1-month CDs. Today, that spread is down to 10 basis points. Even five-year CD rates have dropped well below 1 percent, meaning that there is very little reward for a long-term commitment these days.
- Credit card debt is overly expensive. Credit card debt is essentially a form of short-term borrowing, but credit card rates haven't come down nearly as much as other interest rates, and they've actually risen slightly since the beginning of 2013. As a result, credit card debt has become a more expensive form of borrowing relative to other options. Over the past 10 years, the average rate charged on credit cards was 2.26 percent more than the average rate charged on a two-year personal loan. This spread has now widened to 2.89 percent, an indication that credit cards have gotten relatively more expensive.
- Mortgages are nearly cost-free in real terms. While credit cards have become a relatively more expensive form of borrowing, mortgages have become unusually cheap. Over the past 40 calendar years, mortgages have averaged 8.72 percent while inflation has averaged 4.4 percent, meaning that lenders have demanded an average premium over inflation of 4.32 percent. Now, mortgage rates are below that historical rate of inflation, and only about 1.5 percent above the recent annual inflation rate.
Generally speaking, there is less of a gap between short-term and long-term interest rates these days. That means long rates are a relatively bad deal if you are a depositor, and they are a relatively good deal if you are a borrower. Therefore, if you have the opportunity to lock in a mortgage that you can afford under today's conditions, you shouldn't delay. The normal relationship between time and interest rates may have been disrupted, but timing still matters in some respects.