I have read that the central bank has an interest rate which affects the rate at which banks borrow and lend federal reserves to one another.
What I am confused about is how the central bank's interest rate affects individuals, for example, how the central bank interest rates affects the interest rate of a loan or mortgage.
Why do personal loans and other commercial bank services interest rates change based on the central bank's interest rate?
When the Central Bank raises it's interest rate, it becomes more expensive for banks to borrow money from the Central Bank. Thus, they must charge more when lending it out (to both individuals and businesses).
Conversely, when the Central Bank lowers it's interest rate, it becomes less expensive for banks to borrow money from the Central Bank. Thus, they can charge less when lending it out (to both individuals and businesses).
Broadly speaking, the rate on a loan can be thought of as composed as two parts-- the risk-free rate and the rate the lender requires to deal with the risk of the loan. So
loan rate = risk-free rate + risk premium
The risk-free rate is the rate at which the central government can borrow (ignoring the very, very small risk that the United States or another major Western government would default on their debt). And that rate is basically the rate that the central bank sets (it's not exact but close enough for our purposes). If the bank didn't lend out their deposits to borrowers, they could make the risk-free rate by lending to the government (buying government bonds).
Then you add in the rate that the bank needs to charge in order to account for the risks on the particular loan. If you're putting up appreciating collateral (like a house), you'll get a better rate than if you're putting up depreciating collateral (like a car), which is still better than the rate you'd get if you're not putting up any collateral (i.e. a credit card). You'll get a better rate if your credit score says that you generally pay your debts on time than if it shows a bunch of missed payments. And there are various other risk parameters (income, assets, etc.)
When the central bank adjusts the federal funds rate, the risk-free rate changes but the risk premium remains (approximately). So the rate a bank wants to charge will change in response.
This totally depends on the mortgage / loan contract.
Some are variable rate. For example, where I live, it's common to have Euribor 12mo + margin as the loan rate. This means your interest rate is fixed for the next 12 months at the Euribor 12mo + margin rate at the interest fixing day. The rate stays the same for 12 months, and then is fixed again for the next 12 months.
Some are fixed rate. Typically loans with over 1 year interest rate are classified as fixed. For example, the rate could stay the same for 10 years. If the loan is longer than 10 years, then the market rate changing would affect the loan rate after 10 years from the start of the loan period.
The benefit of variable rate loans is that you generally can pay it back whenever you want.
In contrast, fixed rate loans typically can't be paid back in every single market condition. The reason is simple. If you have a $100,000 10-year bullet loan at 4% rate, you owe $148,024.43 at the end of the loan period. Now, if 10-year market rates lower to 1%, what does it mean for the bank? You would need to pay back $134,004.58 because paying back only $100,000 would not allow the bank to have $148,024.43 at the end of the loan period.
By allowing paying back fixed rate loans in every single market condition would act as a one-way clutch. As a borrower, you could pay back and refinance your loan every time the market rate becomes lower, so you would benefit from reduced rates. In contrast, the bank cannot demand you to refinance your loan every time the market rate becomes higher.
The Euribor rates aren't exactly the same as the central bank rates, but they respond to changes in the central bank rates. The reason central banks adjust their rates is that the adjustments are reflected in the Euribor market rates.
Let the downvotes begin!
