You probably read the title of this article and thought “Duh. Everyone knows Interest Rates are going up.” What you may not know, though, is that interest rates have been increasing since December 2015. However, not all commercial interest rates have been increasing since that time. So why are rates going up now? Let’s begin by looking how these interest rates are derived.
You may have noticed that commercial interest rates are not like interest rates for home loans, car loans, or credit card loans. Like most loans, commercial loans can have either a fixed or variable rate. Loans with variable rates are typically tied to one of two indices, LIBOR (London Interbank Offering Rate) or WSJ Prime (Wall Street Journal Prime Rate). LIBOR isn’t used frequently at community banks, so we won’t go into detail on this. It’s enough to understand for now that LIBOR is an interest rate index that varies and that banks can use this index to price variable rate loans. Most people are more familiar with WSJ Prime also referred to as Prime. If you asked most people, they might tell you that Prime is set by the Federal Reserve. This isn’t quite correct. The Federal Reserve sets what is known as the federal funds rate. Prime is set by the nation’s largest banks and is typically set at 300 basis points or 3.00% higher than the federal funds rate. This rate is then reported in the Wall Street Journal, which is why it is called the WSJ Prime Rate. Since Prime has historically been tied to the federal funds rate, as the Federal Reserve has increased rates over the last two years or more, Prime has also increased. Commercial loans with a variable rate tied to Prime have therefore increased.
But what about fixed rates?
These aren’t tied to Prime, so how do banks determine what these rates will be? In order to understand commercial fixed rates, it’s important to understand that commercial loans are not priced like home mortgage loans. When individuals purchase a home, they may be able to obtain a 20, 25, or 30-year fixed rate, meaning that the rate of interest on the loan doesn’t change for entire time the loan is outstanding. These loans, while originated by community banks, are typically backed by other entities, such as Fannie Mae, Freddie Mac, larger banks, or insurance companies. These entities have large amounts of investible cash and can therefore absorb a different interest rate risk profile than a community bank. Home mortgage loan rates typically move based on the 10 year U.S. Treasury rate.
So what is a Treasury Rate?
This is debt sold by the U.S. Government. And this rate is set by whatever investors are willing to pay for them. Whew! That’s a lot of information. Now that we know that banks have variable rate loans that can be tied to Prime and home mortgage loans that are sold to third parties and can be tied to U.S. Treasury rates, we can finally discuss how banks price fixed rate commercial loans. For commercial loans, bank will typically offer an interest rate that is fixed for three to five years. Banks will base their interest rate on their cost to obtain those dollars that will be lent. However, the cost of funds can be a difficult number to pin down. Is the cost what’s being paid on interest bearing checking accounts? What about CDs the bank provides, which will have various maturity dates? Because of the difficulty in defining this cost, banks will often ask, “What is the opportunity cost of the dollars we will lend?” Meaning, if the bank simply invested these dollars in a safe investment (say, U.S. Treasuries) what kind of rate could the bank obtain? This becomes the bank’s proxy for the bank’s cost of funds. So, for a 3-year fixed-rate loan, a bank may look at the 3-year Treasury rate, add a spread to cover costs like overhead and risk profile, add an amount for profitability and determine the interest rate for a borrower.
Why are these rates going up?
Now we know that banks often look to Treasuries to determine fixed interest rates. Why are these rates going up? Let’s go back a little over two years ago to February 2016. The Federal Reserve had just raised the federal funds rate to around 0.50% and Prime was 3.50%. On February 11, 2016, the 5-year U.S. Treasury yield was 1.11%. Even with a reasonable spread of 2.50% added to the U.S. Treasury rate, a bank might offer a 5-year fixed-rate of 3.61%. At that time you could fix a rate for five years for only 0.11% higher than the floating rate.
Let’s fast forward to March 2018. Now, Prime is at 4.25% and at March 6, 2018, the 5-year U.S. Treasury is 2.65%. With the same spread of 2.50%, a bank might offer a 5-year fixed rate of 5.15%! The difference between the floating rate and the fixed rate is now 0.90% and while Prime increased 0.75% in that time, the U.S. Treasury increased 1.54%. So what happened?
The U.S. Treasuries are an auction rate and are set by what investors are willing to pay for them. These rates can be influenced by several economic factors including how other investments are performing (stocks, bonds, commodities, etc.), risk tolerance, and the perception of the U.S. Economy as a whole. The rate is what the investor is willing to accept as a reasonable return over the next five years. Therefore, in the past two years, investors’ five-year outlook on the U.S. Economy has improved, which has caused fixed rate to be bid up. Savvy borrowers should continue to watch the U.S. Treasury rates to determine the expected rate they might see from their bank.
If you are interested in learning how Marine Bank might be able to help you protect against interest rate risk, contact one of bankers today!
Written by Eric Flick, VP Commercial Lending Officer