Question about interest rates and the "Real World"

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tx_floods's picture
tx_floods
Status: Silver Member (Offline)
Joined: Feb 28 2009
Posts: 155
Question about interest rates and the "Real World"

I have a question about interest rates in the real world, and how they work. Last week, I was talking with a friend of mine who had just purchased a new (used) car for an extended camping trip he was taking. He needed a little beefier car than the econ model he currently owned. He went to a local dealer, and got what he said was a good deal, "Except for the sky-high interest rate" they charged him.

Now, I don't like to pry into people's business that much, [or, to hack on people when they've done something that, imo, is stupid!] so in this example, we have to fill in some of the blanks, and make some assumptions. If the Fed Prime Rate is zero, or near zero, shouldn't people be getting GREAT interest rates, even for used-car loans? Did he get ripped-off, or is a high interest rate indicitive of something else changing in the market-place? I thought that interest rates for consumer purchases (ie, mortage, auto loans, etc) were tied to the Fed rate. (ie, prime + x%)

For the purposes of this discussion, let's assume this friend has average income, and maybe his credit is slightly below average. Without knowing, let's also assume that his interest rate is 15%. Thanks if anyone can help me to understand all this.

oldbill's picture
oldbill
Status: Member (Offline)
Joined: Jul 13 2009
Posts: 5
Re: Question about interest rates and the "Real World"

The Federal Reserve is attempting to "stimulate" by pushing (inflation) money into the credit system.

This money has to be paid back to the Federal Reserve. The transaction costs of a loan are high for a commercial bank, for a variety of reasons, in addition to the cost of money (which is currently 0.25%). They have buildings, employees, equipment, etc. So even if the money they loan is "free", it has to be paid back, and the expenses have to be paid out of profit (interest received).  

Our financial system is set up to operate on "volume". That way, we get free credit cards, free checking, free toasters (sorry, different era)...which are paid for by our receiving less than CPI inflation interest on our savings. With few people borrowing, the few who are, have to pay more to support the free services, as well as the buildings, employees, equipment, etc.

So seemingly "high" rates for loans are justified, if, the borrower is willing to pay them, and, if the commercial bank hopes to stay in business.

If one does not like the "high" rates, he should save his money and buy something he can afford, for cash.

oldbill

Woodman's picture
Woodman
Status: Diamond Member (Offline)
Joined: Sep 26 2008
Posts: 1028
Re: Question about interest rates and the "Real World"

I think your friend has a high interest rate because he may have a poor credit rating and is therefore a greater risk to the lender.  Based only on the limited facts presented, I question the wisdom of buying a depreciating unecessary asset (second car) at a high interest rate, for a purpose that will not provide a return on investment (camping trip).  "Great" interest rates are even worse though, because we tend to spend even more beyond our means.

Tom

tx_floods's picture
tx_floods
Status: Silver Member (Offline)
Joined: Feb 28 2009
Posts: 155
Re: Question about interest rates and the "Real World"
Woodman wrote:

Based only on the limited facts presented, I question the wisdom of buying a depreciating unecessary asset (second car) at a high interest rate, for a purpose that will not provide a return on investment (camping trip). 

Well, sure! But, you know, guy didn't ask me for any advice about it before-hand. Probably wouldn't have listened, anyway! 

I was mostly curious - Outside of the aspect of his (possibly) poor credit rating, I would have thought that now is a good time to borrow money. I'm just trying to fit all these puzzle pieces together. This piece may not fit, yet. Thanks for your replies.

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