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Wall Street Steward Blog

The Unwelcome House Guest

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Have you ever had a houseguest that immediately “wore out his welcome?”  You know the one…as in the one you want to leave as soon as possible.  No matter how short their length of stay, it is still too long in your book. 

Low interest rates are just like that houseguest.  They are irritating and they stay too long.

While I know you folks are tired of seeing short term CD* rates below 1%, the fact is that banks are making the correct decision to keep them low.  Allow me to elaborate.

Every bank/credit union business model is based on something called a “spread.”  The bank takes in a deposit, pays interest, and then lends out that money at a higher interest rate to other customers so that they can buy a home, car, boat, etc.  The difference between the interest the bank pays and the interest the bank receives is called the spread.  This is the heart of how a bank or credit union operates.

Currently, the unemployment rate in York County is around 13%.  When people do not have jobs, they also do not buy houses and cars.  At the same time, the people that DO have jobs are nervous about the economy and they make even larger deposits into their bank in order to provide a safety net.  

This presents a tough environment in which to operate.  Bank XYZ attracts new money in droves, but cannot lend it out because the pool of employed borrowers is very small.  In cases like this, the bank has no other choice but to invest the money.  Of course, the only suitable investments are safe ones, because the funds have to be kept liquid in case the customer takes a withdrawal of his/her funds.  These safe investments are called “overnight funds” and they are paying an annual rate of .09%.

Ok class, let us follow the numbers here.

Customer puts $10,000 into a 1-year CD paying 0.75% (or $75 per year).  Bank XYZ takes that money and attempts to lend it to someone financing a new home for 15 years at 3.875%.  In this competitive environment, the person chooses another institution, so the bank is left to invest the money in overnight funds earning .09%.

They are paying $75 per year on that $10,000 CD, and yet are earning $9 per year on that money.  This is not a business model that any institution can live with for an extended period of time.  The prudent decision, in my opinion, in this case is to keep interest rates very low.

These rates will likely remain low (and might even go lower) until the economy shows meaningful signs of a recovery.  Depending on which economist you trust, those estimates can range from 2-3 years to 8-10 years.

So, you better let “Uncle Low Interest Rate” get real comfortable on your couch, because he plans on staying a while.   

*CD’s are FDIC Insured and offer a fixed rate of return if held to maturity.
Unemployment figures according to US Department of Labor:  Bureau of Labor Statistics