Surprise, Surprise – Interest Rates to Go Up!

“There is,” says Dr. Benton Gup, “only one way that interest rates can go in the future, and that is up: They are going to increase.”

Gup, professor of finance and Robert Hunt Cochrane/Alabama Bankers Chair of Banking at The University of Alabama, notes that market rates of interest are now at record-low levels. Good news? Bad news? Both, says Gup, depending on whether you are a borrower, investor, or a lender, such as a bank.

“For those who can afford to borrow money, now is a great time to lock in long-term fixed rate loans at low rates,” Gup says. The current market rate of interest on 30-year fixed-rate mortgage loans is about 5 percent.

“But the prospect of rising market rates of interest is not good news for investors who hold long-term bonds,” Gup says. “When market rates of interest increase, the market value of long-term bonds, and other fixed-rate investments, declines. That is not a problem if the investor holds the bond to maturity. However, it will result in losses if the bond is sold.”

Gup says banks have a similar issue.

“They borrow short-term funds at low rates of interest and then make longer-term loans, such as mortgages, at higher rates of interest. The difference between their borrowing and lending rates is called the net interest margin, which is usually about 3 to 4 percent. Banks are paying about 1 percent on deposits, and lending mortgages and other loans at 5 percent or more.”

But, you ask, what happens when market rates of interest increase?

“If the banks are holding long-term fixed rate loans at 5 percent, and their cost of borrowing increases to 4 to 5 percent or more, they will lose money,” Gup says  “That is exactly what happened in the 1980s, when banks’ cost of funds exceeded the returns on their loans, and 1,600 banks failed between 1980 and 1994.

“This explains why many banks are reluctant to make long-term fixed rate loans. The banks that are making long-term fixed-rate loans are probably selling the loans to government agencies, or to other investors, who are willing to take on the interest rate risk.”