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Changes in interest rates

Chris Farrell Sep 3, 2010

Question: I am about to take a private education loan to pay for medical school. The banks have made it very clear to me that interest rates on my private loan is variable and there is no limit to how much it can increase. I am not sure what to expect. So my question is, whats the typical change in interest rates, say, over a period of one year? Magarya, Milwaukee, WI

Answer: I hope you enjoy medical school. It’s exciting. As for the banks, I’m glad that they’re emphasizing the rates on your loans can vary over time and that there isn’t a cap on the increase. At the moment, interest rates are extremely low.

Most economists are projecting modest rate increases over the next several years. The assumption–and I hope they’re right–is that eventually economic activity will pick up and the Federal Reserve will start hiking its benchmark interest rate.

What might that mean in practice? That short-term rates could climb over the next several years to the 2% to 3% range and that long-term rates might go to 4% to 6%. I’m using Treasury securities for these numbers since almost all loans are priced off these benchmark securities. Obviously, the rate on your medical school loan will be much higher.

Short-term rates can bounce around a lot. But the typical rate change is fairly small, certainly less than a percentage point or so up or down from the preceding year. I looked at a couple of charts to examine episodes with more dramatic changes to get an idea of worst case scenarios on the rate increase side of the equation. It looked on the order of around two percentage points.

Your question gave me an excuse to pull off my bookshelf a wonderful book, A History of Interest Rates by Sidney Homer and Richard Sylla. (I love a book that discusses in the introduction the maximum rate of interest on loans was 33 1/3% in Hammurabi’s written code of conduct in 1800 B.C Babylon. Cool.) It confirmed that the two percentage point-plus worst case scenario is reasonable, and that average annual interest rate changes are typically much less.

By the way, the bigger risk is an increase in rates over several years. For instance, during a horrible period in the bond market the average rate on one-year Treasury bills went from 5.88% in 1976 to 14.78% in 1981. Ouch. (Here are the average yearly numbers: 5.88%; 6.09%, 8.34%, 10.67%, 12.05%; and 14.78%.) I think there are good economic and financial reasons why we won’t go back to the late ’70s and early ’80s, however.

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