Nov 3, 2020

Doughnuts and Interest Rates

doughnutsTwenty plus years ago, just as I was getting into the real estate business, interest rates sat at 7.5 percent. And they were on their way up.

By the end of 1994, they hit 9.5 percent.

Even as the market started to get hot, in the early 2000’s, borrowers were still looking at about 8 percent for a loan. Fast forward to 2008, when the market crash was just on the horizon, and rates still hung close to 7 percent with a slow and steady decline for the next several years until we reached a bottom in the latter part of 2010 and into 2011.

Sometime in 2011, rates started bouncing along at 4 percent and we all gasped! ‘4%!!!! No WAY!!! This can’t last,’ we all said … but we were wrong.

Since then, no matter how many economists or bankers or pundits predict a climb, we’ve been hovering right around that 4 percent figure, give or take a couple dozen basis points.

[graphiq id=”hGy5vrZ5EV” title=”Mortgage Loan National Overnight Average Rate 30 Year Fixed” width=”600″ height=”587″ url=”” link=”” link_text=”Mortgage Loan National Overnight Average Rate 30 Year Fixed | FindTheData”]

It’s crazy.

How did it happen?

Well, the market began to crater in September 2008 after several banks and investment houses (some small, several quite large) began to fail. In order to stave off financial catastrophe, the Federal Reserve took the unprecedented action of flooding the market with cheap money and actually buying stakes in lenders in order to prevent collapse. Its leaders understood that banks would simply stop making loans if every available asset was basically losing value, and quickly. But if cheap money was available, the lending would continue—though clearly not at the normal rate—thus preventing the economy from going totally stagnant. The Fed did this by dropping its lending rate to 0% and forcibly pumping money into the system via the Quantitative Easing programs.

And while the opinion of many will differ as to the overall success of the actions undertaken, I think most would agree that inaction would have been far worse.

So as we now sit with 2008 in the rear view mirror, we have this fascinating interest rate environment where we have rates hovering at or near the lowest rates (like EVER!) and no real pressure for them to rise. These conditions are extraordinary and almost unique in the modern era.

So to be in the real estate market is to be a person faithfully tuned into the interest rate market. And that means you’re going to get a lot of questions: Up? Down? Should I lock in? Fixed rate? ARM? Hybrid? Perhaps? Yes? No? Maybe? Depends?

As complicated as those questions and answers can be (and they vary for everyone and every situation,) I’ve got to take a stab at laying out interest rate fundamentals. But be clear—this post is going to include more than its share of oversimplifications.

What is an Interest Rate?

An interest rate is what a lender needs to earn from a borrower as a return for risking its money. In theory, the lender receives compensation (interest) that is consistent with the amount of risk the loan carries.

Lots of factors go into this calculus. Lending money to the local orthopedist or established attorney to buy a home in the posh part of town is most likely a less risky proposition than loaning it to your neighbor Bruce who wants to open a sugar-free donut restaurant. Common sense suggests that the doctor or attorney is more likely to pay his loan back than Mr. Donut is so (in theory) they should get a lower rate and better terms.

So what you really have at play, driving the rate and terms of any loan, are three basic factors:

  • The ‘Pure Rate’ or ‘Risk-Free’ Rate
  • Repayment Risk
  • Inflation Risk

Each is discussed below.

The Pure Rate

Say you’re a lender and you’re making the safest loan known to mankind, one with zero risk of default AND the money you would get back would have the same value as that which you lent. How much would you charge? That is the definition of the ‘Pure Rate’ of interest.

I have seen studies suggest the Pure Rate is between 2-3%. To put it simply, that Pure Rate of 2 percent is the bottom of all rates, the safest possible. Anything higher would suggest that there are risk factors involved.

Make sense?

So we begin all conversations about pricing interest rates with the ‘pure’ rate of interest and build from there.

Repayment Risk

So, using the donut maker example from above, assume you loaned him $50k to buy an oven, lease a storefront, and buy a whole lot of flour and whatever chemical is going to try to mask the lack of flavor.  How likely is it that you’re going to recoup that loan? Let’s say ‘less than 100 percent.’  So you’re taking on some level of risk—and let’s assume it’s substantial because who wants a sugar-free donut. You should charge the foolish entrepeneur a higher rate of interest.

Now let’s think about loaning against owner-occupied real estate. Banks like this loan because there’s relatively low risk to do so.

Banks have long operated on the assumption that when push comes to shove, you will make the mortgage payment before you make your rental property payment or your RV payment. This is due in part to the fact that the bank can always take the home back and sell it to cover the outstanding loan balance.  For as long a time as anyone can remember, this has made lending against a home a secure investment for banks (ignoring, of course, 2008 – 2011).

(To keep things simple, we’re going to forget about the impact that underwriting factors have on the repayment risk. Down payment, loan limits, asset types, the GSE’s (Fannie Mae, Freddie Mac, Ginnie Mae) all can influence risk to a certain level. For the most part, though, the difference between a Maximum FHA loan with Mortgage Insurance and a Conventional Fannie Mae 80% is less than 1% in APR.)

Always remember this – historically, banks are in a pretty safe position when they make a loan guaranteed by your home, even despite the recent mortgage debacle.

Inflation Risk

Everybody’s got a parent or grandparent who can tell you how much a cup of coffee or a gallon of gas cost decades ago. Same goes for mortgages.

To illustrate, if you took out a loan to buy a home 30 years ago, and made your last payment today, you would have paid the bank back with money that used to be worth far more:

  • gas was $1.09/gallon in 1985
  • the average new home cost $89k in 1985
  • the average new car was $9k in 1985

It’s hard to get your mind around those numbers, right?

There’s no doubt that the value of money has changed over time. A dollar becomes worth less and less when its buying power decreases—we all call it inflation. (Deflation occurs when prices drop, and this happens mostly in South American economies ruled by despots … but I digress.)

It makes sense that when a borrow pays a lender the $100,000 in principal on a loan over 30 years, the payments toward the end of the loan will be worth less. A lot less. That’s why banks have to charge interest.

So when a bank commits to lending you money for 30 years, they need to make sure that they’re taking inflation and the change in the value of money into account. That rate they charge you reflects what they anticipate those costs will be.

Pricing Mortgage Interest Rates

Ok, given all of the factors, how are mortgage rates priced?  Think of it as adding the three components together:

The Pure Rate + Repayment Risk + Inflation Risk = Interest Rate

Now, it’s just about math. Kind of. If you know the ‘Pure Rate’ is largely fixed and the Repayment Risk is pretty small, then the difference must be inflation, right?

You better believe it.

If interest rates are in the 3 – 4% range, the banks are telling you that they think there’s a pretty slim chance that prices for the core goods and services in our economy will rise substantially in the immediate future. Look at the roller coaster ride that is the Chinese stock market; the likelihood of the world economy getting overheated again (at least for the foreseeable future) is fairly slim and thus, rates should continue to be quite enticing for some time.

The Fed vs. ‘The Market’

One thing most people just don’t get is who is doing the actual interest rate pricing. Note this – the Fed does not set mortgage rates. Nope. It’s actually set by something you might have heard of called  ‘the market.’

So what is this ‘market’ you are referring to? The ‘market’ that drives the price of money is a complex and nuanced collection of currency exchanges, the bond market, Wall Street, the Federal Reserve (yes, they’re part of it), both large and small banks, puts, calls, options, derivatives … the whole ball of wax … it all has an impact on the price of money.  These entities constantly look into the future and either buy or sell the right to money at specific prices based on what they see for the future.

When money is in demand and supply is fixed, interest rates tend to rise.  Conversely, when people aren’t looking for money (say, in a recession) and the supply is higher, then the prices will tend to drop (think 2012.)  The Fed has tremendous power to increase or decrease the money supply to INFLUENCE the rates, but they do not set them. When you see or read anything about the Federal Reserve announcing QE II or leaving the Federal Funds Rate alone, they are simply using the tools at their disposal to move the supply of money and how much it costs in hopes of properly supplying the needs of the capital markets. It’s quite a captivating dance.

Remember, the Federal Reserve cannot set the price of money, only influence it. Imagine driving your car with the mandate of keeping it at pretty much the same speed without using the brakes. You can speed up by hitting the gas pedal or you TRY to slow down by downshifting or coasting. Ultimately, things like gravity and weather and road conditions (don’t crash that rate into a tree) are what will finally bring your car to a standstill. But know that the Fed can only do so much.

Long Term vs Short Term Rates

No discussion on interest rates would be complete without pointing out how long-term and shorter-term rates are priced.

Basically, as a borrower, you have two mortgage product options – fixed-rate products or adjustable-rate products.  As one one would expect, a fixed-rate mortgage has a rate that stays steady over the life of the loan while an adjustable-rate loan fluctuates at specific intervals based on a specific index.  What is really happening is the risk of inflation is being redistributed depending on who has the right to the rate and for how long.

In an adjustable-rate mortgage, the borrower carries the inflation risk by agreeing to allow their rate to periodically adjust to market conditions. In a fixed-rate mortgage, the lender carries the inflation risk as they CANNOT change the rate, even if inflation increases.  It is why you typically see adjustable rates trade lower than fixed ones.

An interesting note is that in recent history, the difference between the adjustable-rates and fixed-rates (sometimes referred to as the ‘spread’) has been extremely small. Why?  If you guessed ‘low expectation for inflation’ then you are beginning to get the hang of this!


If and when we begin to see all rates rise, it will be for one of the following reasons:

  • The global economy is heating up (or at least the Market sees it that way)
  • The Federal Reserve shrinks the money supply
  • The Federal Reserve decides to increase the rate at which they charge banks to borrow money

And specifically, if you see the long term rates rise, it is because the market is anticipating inflation. Now, if you see short term rates rise, it is due to the Fed trying to influence the market.

The interest rate markets and pricing models are extremely sophisticated. Those who buy, sell and loan money for a living—and actually make money at it—are very sharp. That said, even if you are not a professional, having the ability to understand the correct way to finance properties can save hundreds of thousands of dollars over your lifetime. Spend some time understanding interest rates … you will be handsomely rewarded for it.