Melinda Jacobsen is a successful business executive planning to retire in 10 years. She desires recommendations for possible refinancing options that will help her decide the best choice for her retirement. Similarly, Jacobsen is considering refinancing her home to provide additional funding for long-term retirement investment. Similarly, this recommendation covers the Federal Reserve and its effect on interest rates. This assignment, therefore, explains the Federal Reserve, how it affects interest rates, the possible loan options and a final recommendation of the best loan she should choose.
Federal Reserve and Interest Rates
The Federal Reserve is mandated with the responsibility of ensuring full employment in addition to checking the inflation of the country. The Federal Reserve influences the direction of interest rate using different tools including open market operations, discount rate and reserve requirements. Open market operations (OMOs) involve the purchase and sale of securities to the general market by the central bank. The free market operations constitute temporary and permanent. The central bank can use the permanent OMOs to check long-term factors that lead to the expansion of the Federal Reserve particularly the currency in circulation. OMOs can be used during the financial crisis to adjust the Federal Reserve to ease the pressure on long-term interest rates. Permanent OMOs is currently used to implement Federal Open Market Committee policies that focus on reinvesting principal payments. Similarly, the OMOs can also be used to extend the maturity of Treasury securities with the aim of reducing the pressure on long-term interest rates.
Delegate your assignment to our experts and they will do the rest.
The Fed discount rate is the rate at which the central bank charges commercial banks that borrow from the overnight discount window with the intention of maintaining their reserves. Currently, the discount rate is at 2.75% September 27 th 2018 when the board of governors raised the rate. The central bank has three credit rates that include the primary credit rate which is charged to the majority of banks and is higher than the federal funds rate. The secondary credit rate is charged to bank s that fall short of the requirements for the primary rate. The third is the seasonal discount rate that applies to small community banks in need of cash for the demands by local borrowers (Kennon, 2016). Discount rate affects the interest rate by raising or lowering the interest rate. An increase in the discount rate reduces the supply of money in the market since financial institutions are likely to reduce their overnight borrowing. The result is that banks will be hesitant to lend more money leading to an increase in the interest rate.
Reserve requirements are the cash amounts that commercial banks must deposit with the central bank according to customer deposits and cannot be loaned to customers. Banks can only lend a fraction of the customer deposits and maintain some cash for withdrawal purposes. Banks can also receive interest from the central bank for excess reserve. Banks have a reserve requirement depending on a threshold that is adjusted annually. The reserve requirements do not apply to banks with less than $16 million in deposits.
Similarly, banks whose deposit is between $16 million and $122.3 million have to maintain a 3%. Any banks whose deposits exceed $122.3 million are required to maintain a 10% reserve. A decline in the reserve requirements leads to an increase in liquidity, and an increase reduces the cash in the market, therefore, affecting the interest rate.
Loan Options
The yield curve above is a standard yield curve. The curve indicates that lending money for ten years is safer compared to 30 years. Lenders, therefore, expect to earn higher compensations for amounts given for a longer time. An increase in the number of years leads to a rise in interest rates since lenders perceive 30 years as having more risks than ten years. As the number of years reduces, so does the interest payable indicating that lenders feel more secure giving out their money for a shorter term compared to a longer one. An increase in the time leads to a similar rise in the interest rate as lenders expect to be paid more interest to compensate for the extended period.
Risk and inflation significantly affect the interest rates following an increase in the number of years. Lenders are risk-averse and prefer shorter periods like ten years compared to the more extended periods. According to them, the more the time it takes to repay the loan the higher the associated risk, and therefore the interest must be higher in more extended periods. Similarly, inflation erodes the real value of the mortgage over time and makes the yield curve steeper (Najafov, 2015). The longer the repayment period, the higher the chances that inflation will grow at a higher rate reducing the absolute value of the loan. Risk and inflation, therefore, reduce the expected returns of a mortgage as time increase. Investors are therefore likely to prefer lesser repayment periods compared to longer times like 30 years because they are not sure of any significant change that can adversely affect loan repayment or the real value of the loan.
Recommendation
Jacobsen should consider a mortgage that offers the best value for money. According to the above discussion, a 10-year mortgage will be the best option for her to take. The reason for choosing this option is based on the interest rate payable by Jacobsen. According to the yield curve, a ten-year mortgage has the lowest interest rate which is friendly to any borrower. The decision to recommend the 10-year mortgage was based on the assumption that the prevailing conditions will remain the same. Similarly, the conclusion assumes that there are no other factors that are considered apart from the interest rate. However, if the time value for money is found, the best mortgage for Jacobsen will be the 30 years since the future amounts will be lower than a 10-year mortgage as long as the discounting factor remains the same.
References
Kennon, J. (2016). How the Federal Reserve Controls Interest Rates. Retrieved from https://www.thebalance.com/the-federal-reserve-and-interest-rates-357315
Najafov, S. (2015). Monetary Policy Under Condition of Crisis of Traditional Tools. SSRN Electronic Journal . doi: 10.2139/ssrn.2614114
The Fed - Open market operations. (2018). Retrieved from https://www.federalreserve.gov/monetarypolicy/bst_openmarketops.htm
