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When we talk of 'rising interest rates' or 'falling interest rates', which interest rates are we referring to? - The interest given to the individual by the bank on a savings account? - The interest the bank charges on a mortgage? - The interest the credit card charges us on defaulting?

I guess all of them are related, but which one is the major actor being referred to in statements like "Interest rates are at all time low." And how are these interest rates related?

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You are correct that it could refer to any of the types of interest rates that you've mentioned. In general, though, phrases such as "rising interest rates" and "falling interest rates" refer to the Federal Funds Rate or LIBOR. These are the interest rates at which banks in the U.S. and U.K., respectively, are lending money to each other.

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    And this matters because the banks use this as the base to lend to you. And that rate would always be higher than the base rate. – MoneyCone May 3 '11 at 21:47
  • When you say :base, you mean Prime? – Victor123 May 3 '11 at 22:23
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    Base rate and Prime usually the same; different countries, different terminology. – Turukawa May 4 '11 at 7:04
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As Sean pointed out they usually mean LIBOR or the FFR (or for other countries the equivalent risk free rate of interest). I will just like to add on to what everyone has said here and will like to explain how various interest rates you mentioned work out when the risk free rate moves:

For brevity, let's denote the risk free rate by Rf, the savings account interest rate as Rs, a mortgage interest rate as Rmort, and a term deposit rate with the bank as Rterm.

  • Savings account interest rate: When a central bank revises the overnight lending rate (or the prime rate, repo rate etc.), in some countries banks are not obliged to increase the savings account interest rate. Usually a downward revision will force them to lower it (because they net they will be paying out = Rf - Rs). On the other hand, if Rf goes up and if one of the banks increases the Rs then other banks may be forced to do so too under competitive pressure. In some countries the central bank has the authority to revise Rs without revising the overnight lending rate.

  • Term deposits with the bank (or certificates of deposit): Usually movements in these rates are more in sync with Rf than Rs is. The chief difference is that savings account offer more liquidity than term deposits and hence banks can offer lower rates and still get deposits under them --consider the higher interest rate offered by the term deposit as a liquidity risk premium. Generally, interest rates paid by instruments of similar risk profile that offer similar liquidity will move in parallel (otherwise there can be arbitrage). Sometimes these rates can move to anticipate a future change in Rf.

  • Mortgage loan rates or other interests that you pay to the bank: If the risk free rate goes up, banks will increase these rates to keep the net interest they earn over risk free (= Δr = Rmort - Rf) the same. If Rf drops and if banks are not obliged to decrease loan rates then they will only do so if one of the banks does it first.

P.S:- Wherever I have said they will do so when one of the banks does it first, I am not referring to a recursion but merely to the competitive market theory. Under such a theory, the first one to cut down the profit margin usually has a strong business incentive to do so (e.g., gain market share, or eliminate competition by lowering profit margins etc.). Others are forced to follow the trend.

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I would say people are generally talking about the prime lending rate. I have heard the prime lending rate defined as "The rate that banks charge each other when they borrow money overnight." But it often defined as the rate at which banks lend their most creditworthy customers. That definition comes with the caveat that it is not always held to strictly. Either definition has the same idea: it's the lowest rate at which anyone could currently borrow money.

The rate for many types of lending is based upon the prime rate. A variable rate loan might have an interest rate of (Prime + x). The prime rate is in turn based upon the Federal Funds Rate, which is the rate that the Fed sets manually. When the news breaks that "the Fed is raising interest rates by a quarter of a point" (or similar) it is the Federal Funds Rate that they control. Lending institutions then "fall in line" and adjust the rates at which they lend money.

So to summarize: When people refer to "high" or "low" or "rising" interest rates they are conceptually referring to the prime lending rate. When people talk about the Fed raising/lowering interest rates (In the U.S.) they are referring specifically to the Federal Funds Rate (which ultimately sets other lending rates).

  • Prime + x? For the mortgages in Canada, all banks are talking in terms of Prime - x. – Victor123 May 4 '11 at 16:32
  • Wow. I've never heard of that. – Stainsor May 4 '11 at 16:56

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