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Elements of Interest Rates

By Steve Lauver

Real Estate Agent with Nebraska Realty - NE RE# 20030540

March 20, 2008 02:49 AM

I have been asked several times over the past few weeks "What do think interest rates going to do this year?" This is a tough question to answer unless you understand the different elements of interest rates. Elements of interest rates? What that? The following is a few of the major elements that effective interest rates.

Elements of Interest Rates:

Interest rates for loans, mortgage or note/bond are all composed of various levels of risk. The following is a basic equation for interest rates.

Interest Rate = Risk Free Rate (RFR) + Inflation Risk (IP) + Default Risk Premium (DRP) + Liquidity Rate Premium (LRP) + Maturity Rate Premium (MRP)

The risk free rate (RFR) is the US treasury note/bond interest rates. The US Government has never default on note/bond and it most likely never will. If they do, our economy will have much bigger problems then the mortgage market crisis. That's why so many investors around the world buy US Treasury notes and bonds, because they are safe.

Inflation Premium (IP) is the amount of expected inflation to occur over time. Every one that has been to a gas station, grocery store, or mall has noticed goods and services are costing more. Just the other day, I was at McDonald's and noticed the price of pancakes increased from $1.50 to $1.69 or 12.67%. Milk and Bread have increase much more then 12% over the past 6 months.

Default Risk Premium (DRP) is the risk associated to the mortgage, loan, note or bond that they will note get paid back all of its original investment. This is a big problem with mortgages right now. The increase in foreclosures and declining property values cause investors to worry about getting all their money back.

Liquidity Risk Premium (LRP) is how easy an investor can sell his loan, mortgage, note/bond to get its money back. This means what is the supply and demand for the particular product.

Maturity Risk Premium (MRP) is the longer the term generally the higher the interest rate. However, the more liquid the market the less this is a factor impacts the rate.

So looking at all the components, what's the direction of interest rates? At this point up. Inflation is definitely increasing. I think this is the biggest factor that needs to be addressed in order to bring rates down. Consumers have been pushed a little too far with the current price of oil, gas, and other commodities. Liquidity and the risk of defaults have been a problem in the secondary mortgage market. I would not be surprised to see the government enter the mortgage market and become a buyer of mortgage bonds, which would increase demand and lower rates.

Best regards,