Financial firms use indices to track average yields on securities and interest rates on loans. Mortgage rates are compared to government bond yields, with mortgage rates set higher due to higher risk. Variable rate loans and deposit products are also affected by index values. Economists use indices to predict housing market activity and overall economic health.
Financial firms use various types of indices to track the average yield on bonds and other types of securities, as well as to track the interest rates charged by lenders for consumer and commercial loans. The current value of the index represents the average rate paid for the securities or loans in a particular index at a specific time. Economists track indices to measure the overall health of the economy within a particular region or nation.
In many countries, consumer mortgages are grouped into investment funds; The bonds linked to these funds are sold to investors. Like mortgages, government bonds are debt securities, and investors compare the yield paid on mortgage funds to the yield paid on long-term government bonds. In general, government entities are considered low-risk borrowers compared to homeowners. Consequently, mortgage rates must be higher than the rates paid on government bonds; Otherwise, investors would have no incentive to buy these funds instead of buying government-issued debt. Lenders generally set mortgage rates at a certain range above the current index value of indices that track rates on national government bonds.
In addition to fixed rate loans, variable rate loans are also affected by the current index value of various government bond indices. The interest rate on a fixed-rate loan depends on the average rate of the bonds at the time the loan is issued. With variable rate loans, lenders set the interest rate at a particular range to the average value of the index. When the bond index rises, the borrowing rate rises along with it, while the opposite occurs when bond interest rates begin to decline. Different lenders review ratios and change rates on variable rate loans at monthly, annual, or multi-year intervals.
Banks normally pay fixed interest rates on deposit products, but some banks use variable rates that are based on indexes. In products such as Certificates of Deposit (CDs), banks may pay a return that depends on the current index value of a bond index at the time the CD reaches maturity. Other financial institutions base returns on indices that track the performance of the stock market. These banks pay monthly returns if certain stocks in a particular index increase in value over a particular period of time. By contrast, banks often pay depositholders nothing if the securities listed in a particular index lose value during a CD term.
Economists use government bond indices and similar performance indicators to predict future levels of activity in the housing market. If bond indices rise, borrowing becomes more expensive and this makes financing residential property more expensive. Furthermore, these price increases can have knock-on effects that cause inflation throughout the economy. Thus, an economist can make a prediction about an upcoming economic boom or recession based in part on the current index value of various charts that track the performance of bonds and securities.
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