The Three Interest Rates

Photo: Miusam Saleem

I got a notice from one of my credit cards a bit ago, announcing that they were raising the interest rate. It's only of theoretical interest to me, of course--I use credit cards for transactions, not to borrow money--but looking at the rate they're charging reminded me that there are really three interest rates.

Of course there are an infinity of different interest rates, but I find I think of them in three broad categories:

  • The rate you have to pay
  • The rate the big boys have to pay
  • The rate you can earn on your savings

These rates used to have a particular relationship to one another. (People used to talk about bankers following the 3-6-3 rule: Take deposits at 3%, make loans at 6%, and hit the golf course by 3 PM.) Things haven't been that way in a long time--and it really bugs me.

Rates you have to pay

The credit card I just got new rate terms for has a variable rate. I don't know what the old rate was, but the new rate will be prime plus 9.74%, which currently works out to 12.99%. That's better than a lot of credit cards, but it's still a terrible way to borrow money.

The banks, of course, claim that they need to charge these high rates to cover the costs of running a whole transaction system, and to make up for all the people who don't pay their loans off. Personally, I'd find that a lot more convincing if I didn't know that they covered the cost of the transaction system by charging the merchants transaction fees and if they didn't load up even higher rates (along with a bunch of fees) on everyone who began to look like they might default.

Still--it's a free market and all that. If you don't want to pay those interest rates, you're free not to borrow money.  That's what I do.

Rates the big institutions pay

The news often reports the rates that big institutions pay. The prime rate used to be big, although it's become less important of late. The US treasury has to pay just a fraction over 3% to borrow for 10 years. The Fed Funds rate (the rate banks pay each other when they lend/borrow overnight) is around zero (0.17% on July 29th), down from over 5% before the economic crisis hit and the Fed hit the panic button. During the crisis the Fed has been making money available via a temporary program called the Term Auction Facility. They just lent out $82 billion for four weeks at 0.25%.

Understand: the Fed has done this on purpose. A big part of the reason things are like this is that after the big financial institutions trashed their balance sheets by lending huge amounts of money to people who would never be able to pay it back, it became necessary to recapitalize the banks. The Fed and the Treasury lent them billions to keep them together during the crisis, but the only hope for the banks ever paying that money back is for the banks to be hugely profitable.

If you could borrow at 0.25% and lend at 12.99% you could be hugely profitable too. Of course, that's not going to happen.

Rates you can earn

For a decade or two, back in the 1980s and 1990s, savers had a pretty sweet deal. Savings accounts, CDs, treasury paper, even savings bonds paid great rates. Through most of the 1980s it was possible for ordinary savers to get 5 percentage points over inflation. That gradually narrowed--through the 1990s the difference was down to about 2.5 percentage points, but it was still pretty sweet.

Then, in 2001, rates that savers could earn collapsed.  From a very satisfactory after-inflation return of over 3% in 2000, rates fell almost to zero. In fact, the after-inflation return to savers has often been negative, starting in 2002.

The fraction of their income that American's saved collapsed to around zero in 2005 or so. There's plenty of blame to go around for that, but you have to figure that an absence of any real return on savings didn't help. Savings have spiked up now, because everyone is afraid, but they won't stay up if savers can't earn anything.

What to do?

First of all, unless you can borrow at 0.25% or so, don't borrow any money. That's the easy part.

There's really no solution for the way savers are getting screwed. Reported inflation is momentarily low, but that's about to change (once last fall's big declines in fuel prices drop out of the year-ago calculations). I'll be very interested to see if savers put up with negative real returns, once the reported inflation rate surges.

Until rates for savers move up, about all you can do is shop around for the best returns on savings accounts and CDs, and invest some of your money in non-financial investments (such as stocking your pantry with stuff you're going to use anyway, and putting cash into things like better insulation and weather stripping that'll pay a return in the form of reduced future expenses).

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Guest's picture

Excellent advice. Unfortunately many saver friends of mine could not handle getting 1 or 2% interest on their savings so they went into the stock market and lost half of their savings. If these people had taken your advice at least they would still have their savings intact. Keep up the good work.

Guest's picture
Common Sense Will Not Kill You

My wife and I are averse to risk and are also big savers. This is a very frustrating situation for us. Used to be that even 5 years ago, we'd finance our vacations off the interest from our savings. Needless to say, no vacations planned for the near future.

IMO, for all the lip service about wanting people to save, I think that the powers that be don't want people to stuff money into savings cash accounts. They want you to lubricate the economy by spending that money.

Guest's picture

Credit Card companies make huge profits on merchants fees.
It's only an excuse to make more money for them and increase the rates. It looks like a cartel to me that control prices.

More to that, merchant cash advance companies are much dangerous loan sharks that take advantage of merchants by charging %40 for 4 month and fees.

Guest's picture

Great advice here, pretty helpful, and the graphs are great visuals.

Guest's picture

"Neither a borrow nor lender be" goes the old saying, but in reality some borrowing is good - if you're borrowing to buy an asset, such as a home, then that is "good" borrowing.

If you're borrowing to buy luxuries - latest LCD TV, designer clothes etc - then that is "bad" borrowing - borring money to buy a depreciating asset serves little purpose other than to strip you of more of your own personal cash.

Like many other, I used to borrow to fund a lifestyle which I could not afford - this all changed 15 years ago - I am now free of all debt and feel great about it.

Cut up those credit cards - you don't need them - live within your income - either cut expenditure or get a better paying job!

Philip Brewer's picture

@ Simon:

I have a post called Good debt, bad debt, that talks about those issues.

Personally, I put debt to buy a house in the second best category of debt--not as good as debt to buy an income-producing asset, but better than debt to buy stuff you can't afford.

A house may be an item of enduring value, but that depends to a great extent on what price you pay for it.  If you pay too much for a house, it might never be worth what you paid for it.  (And that's totally aside from the issue of whether or not you can actually afford the house--and we've all now seen what happens when people do that and then aren't bailed out by rising house prices.)

Guest's picture

In the last 5 months I had the interest rate jacked up on 3 credit cards. All of them were with Chase bank, thanks to their acquiring Washington Mutual. I could have "closed" those accounts and kept the same interest rates. That would have negatively impacted my credit score. Luckily I was able to get a zero interest loan from family and just pay the cards off. Here's the interesting part. I was never late on a payment or ever went over my limit. Chase still raised the rates on my cards and refused to even discuss alternatives. Card A) raised from 9.99% fixed to Prime rate (3.25%) plus 9.99%. Card B) raised from 10.99% to Prime plus 9.99% but card C) was raised from 13.99% (barely used just to keep the card active!) to Prime rate plus 16.99%.
My income is such that technically I'm classified as "The Working Poor" (27k a year for me)How many other people are being penalized on their credit card rates just because they don't make lots of money and don't have family who can bail them out?
It seems to me that the banks are attempting to recoup the losses they incurred (while gambling with our money!!) by financially raping the people least able to afford it. How many more families will be forced into bankruptcy by these changes?
I'm curious as to what your readers think about these changes and if the middle class is even aware of how the poor are being further brutalized. Your thoughts?
On a side note, I'm also attempting to purchase a home. The only ones in my price range are bank owned already. The only reason I haven't been able to get a house (I've already pre-qualified!) is because the banks that own the homes refuse to make the mostly minor repairs that would let the houses qualify for VA or FHA financing. Just another policy that keeps the working poor from bettering their lot in life.
Thanks for letting me vent and hopefully make more people aware that, as always, the people who already have it the worst pay a disproportionately high price for a failing economy.

Guest's picture

Chase did the same thing to me. I've been with WAMU for a decade. They bumped my credit card from 14.99% to 28.9%. I don't have a great credit score because I relied on my credit cards for a couple of years while fighting with Worker's Compensation and was unable to work BUT I have always paid on time and pay more than asked (usually 2x the minimum). To add to the bump in rates, they just closed my account. I was planning to close my account with them when I pay it off (which I will be doing in the next month or two) but even still, I felt offended that they closed the account because they decided that I might not pay.

I've decided to close the other card accounts I have except for one because the others also bumped my rates unreasonably high. The one is staying open because they lowered my rate when I asked. I'm also closing my now Chase checking account. I've been using ING primarily for years and was using my WAMU account for fast deposits, etc. I don't want that company handling any of my money in the future.

Guest's picture

Kind of funny that the first graphic for this story appears right in the middle of Discovery Channel's annual Shark Week. {cue music from Jaws}

The negative after-inflation return on savings is very frustrating for this debt-free family. We'd like our savings to be helping us instead of it shrinking away...

Guest's picture

steve -- fwiw, I bought my first home on an FHA loan, and they required a bunch of minor repairs the seller didn't want to fool with making. I really wanted the house, and it came through inspection beautifully IMO for its age, so I did the repairs myself. I felt there was little risk to me, since I had a contract, and the items FHA tagged were not very expensive and were things I could do myself. For example, the repairs were painting over lead paint on exterior windows, and putting a piece of plywood over the opening to the attic, to close it off. I ended up closing on the house on time, and had no regrets.

With a contract and adequate inspection report in hand, I would not hesitate to do my own repairs again, in order to get into a program like FHA.