How Interest Rates Affect the U.S. Markets

 Changes in interest rates can have both positive and negative effects on the markets. Central banks often change their target interest rates in response to economic activity: raising rates when the economy is overly strong, and lowering rates when the economy is sluggish. In the U.S., when the Federal Reserve Board (the Fed) changes the rate at which banks borrow money, this has a ripple effect across the entire economy. Below, we will examine how interest rates can have an effect on the economy as a whole, the stock and bond markets, inflation and recessions.

When central banks like the Fed change interest rates, it has a ripple effect throughout the broader economy.

Lowering rates makes borrowing money cheaper. This encourages consumer and business spending and investment and can boost asset prices.

Lowering rates, however, can also lead to problems such as inflation and liquidity traps, which undermines the effectiveness of low rates.

How Interest Rates Affect Spending

With every loan, there is some probability that the borrower will not repay the money. To compensate lenders for that risk, there must be a reward: interest. Interest is the amount of money that lenders earn when they make a loan that the borrower repays, and the interest rate is the percentage of the loan amount that the lender charges to lend money.

The existence of interest allows borrowers to spend money immediately, instead of waiting to save the money to make a purchase. The lower the interest rate, the more willing people are to borrow money to make big purchases, such as houses or cars. When consumers pay less in interest, this gives them more money to spend, which can create a ripple effect of increased spending throughout the economy. Businesses and farmers also benefit from lower interest rates, as it encourages them to make large equipment purchases due to the low cost of borrowing. This creates a situation where output and productivity increase.

Conversely, higher interest rates mean that consumers don't have as much disposable income and must cut back on spending. When higher interest rates are coupled with increased lending standards, banks make fewer loans. This affects not only consumers but also businesses and farmers, who cut back on spending for new equipment, thus slowing productivity or reducing the number of employees. The tighter lending standards also mean that consumers will cut back on spending, and this will affect many businesses' bottom lines.

The Effect of Interest Rates on Inflation and Recessions

Whenever interest rates are rising or falling, you commonly hear about the federal funds rate. This is the rate that banks use to lend each other money. It can change daily, and because this rate's movement affects all other loan rates, it is used as an indicator to show whether interest rates are rising or falling.

These changes can affect both inflation and recessions. Inflation refers to the rise in the price of goods and services over time. It is the result of a strong and healthy economy. However, if inflation is left unchecked, it can lead to a significant loss of purchasing power.

To help keep inflation manageable, the Fed watches inflation indicators such as the Consumer Price Index (CPI) and the Producer Price Index (PPI). When these indicators start to rise more than 2–3% a year, the Fed will raise the federal funds rate to keep the rising prices under control. Because higher interest rates mean higher borrowing costs, people will eventually start spending less. The demand for goods and services will then drop, which will cause inflation to fall. 

A good example of this occurred between 1980 and 1981. Inflation was at 14% and the Fed raised interest rates to 19%.1 2 This caused a severe recession, but it did put an end to the spiraling inflation that the country was seeing. Conversely, falling interest rates can cause recessions to end. When the Fed lowers the federal funds rate, borrowing money becomes cheaper; this entices people to start spending again.

A good example of this occurred in 2002 when the Fed cut the federal funds rate to 1.25%.3 This greatly contributed to the economy's 2003 recovery. By raising and lowering the federal funds rate, the Fed can prevent runaway inflation and lessen the severity of recessions.

How Interest Rates Affect the U.S. Stock and Bond Markets

Investors have a wide variety of investment options. When comparing the average dividend yield on a blue-chip stock to the interest rate on a certificate of deposit (CD) or the yield on a U.S. Treasury bond (T-bonds), investors will often choose the option that provides the highest rate of return. The current federal funds rate tends to determine how investors will invest their money, as the returns on both CDs and T-bonds are affected by this rate.

Rising or falling interest rates also affect consumer and business psychology. When interest rates are rising, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.

Interest rates also affect bond prices. There is an inverse relationship between bond prices and interest rates, meaning that as interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. The longer the maturity of the bond, the more it will fluctuate in relation to interest rates.

One way that governments and businesses raise money is through the sale of bonds. As interest rates move up, the cost of borrowing becomes more expensive. This means that demand for lower-yield bonds will drop, causing their price to drop. As interest rates fall, it becomes easier to borrow money, and many companies will issue new bonds to finance expansion. This will cause the demand for higher-yielding bonds to increase, forcing bond prices higher. Issuers of callable bonds may choose to refinance by calling their existing bonds so they can lock in a lower interest rate.

Interest rates affect the economy by influencing stock and bond interest rates, consumer and business spending, inflation, and recessions. However, it is important to understand that there is generally a 12-month lag in the economy, meaning that it will take at least 12 months for the effects of any increase or decrease in interest rates to be felt. By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will allow us to understand the big picture and make better investment decisions.

How Central Banks Affect Interest Rates

 The central bank for the United States—the Federal Reserve (the Fed)—is tasked with maintaining a certain level of stability within the country's financial system. Specific tools are afforded the Fed that allow for changes to broad monetary policies intended to implement the government's planned fiscal policy. These include the management and oversight of the production and distribution of the nation's currency, the sharing of information and statistics with the public, and the promotion of economic and employment growth through the implementation of changes to the discount rate.

The most influential economics tool the central bank has under its control is the ability to increase or decrease the discount rate. Shifts in this crucial interest rate have a drastic effect on the building blocks of macroeconomics, such as consumer spending and borrowing.

The Fed sets target interest rates at which banks lend to each other overnight in order to maintain reserve requirements—this is known as the fed funds rate.

The Fed also sets the discount rate, the interest rate at which banks can borrow directly from the central bank.

If the Fed raises interest rates, it increases the cost of borrowing, making both credit and investment more expensive. This can be done to slow an overheated economy.

If the Fed lowers rates, it makes borrowing cheaper, which encourages spending on credit and investment. This can be done to help stimulate a stagnant economy.

Overnight Lending and Bank Reserves

Banks are required by the Fed to have a minimum amount of reserves on hand, which is currently set at 0% in response to the COVID-19 pandemic. Previously, the rate was set at 10%. This meant that a bank with $1 million on deposit had to maintain at least $100,000 on reserve and was free to lend out the remaining $900,000 to borrowers or other banks. Each day, bank reserves are depleted or augmented as customers carry out day-to-day banking and make payments, withdrawals, and deposits.

At the end of the business day, if more withdrawals had been made than deposits, the bank may have found itself with too little reserves, say just $50,000 left, and would have been below regulatory requirements. It would then have had to borrow the other $50,000 overnight as a short-term loan.

If another bank saw more deposits than outflows, it may have found itself with perhaps $150,000 available, and so could lend $50,000 to the first bank. It would prefer to lend those excess reserves and earn a small amount of income on it rather than have it sit idly as cash earning zero yield. The rate at which banks lend to each other overnight is called the federal funds rate (or fed funds rate for short), and is set by the supply and demand in the market for such short-term reserves loans.

If there are no banks with reserves willing to lend to those in need, that bank can instead borrow directly from the Fed, at a rate known as the discount rate.

The Fed Funds Rate and Discount Rate

For banks and depositories, the discount rate is the interest rate assessed on short-term loans acquired from regional central banks. In other words, the discount rate is the interest rate at which banks can borrow from the Fed directly.

Financing received through federal lending is most commonly used to shore up short-term liquidity needs for the borrowing financial institution; as such, loans are extended only for an overnight term. The discount rate can be interpreted as the cost of borrowing from the Fed.

Remember, the interest rate on the inter-bank overnight borrowing of reserves is called the "fed funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises. The Fed sets a target interest rate for the fed funds rate, but that actual rate will vary with the supply and demand for overnight reserves. The fed funds target rate is currently set at 0.00%-0.25%. The Fed offers discount rates for three different types of credit: primary credit, secondary credit, and seasonal credit. These discount rates are currently 0.25%, 0.75%, and 0.15% respectively.

The discount rate is generally set higher than the federal funds rate target because the Fed prefers that banks borrow from each other so that they continually monitor each other for credit risk. As a result, in most circumstances the amount of discount lending under the discount window facility is very small. Instead, it is intended to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above its target—it puts a ceiling on the fed funds rate.

Decreasing Interest Rates

When the Fed makes a change to either the fed funds rate or the discount rate, economic activity either increases or decreases depending on the intended outcome of the change. When the nation's economy is stagnant or slow, the Federal Reserve may enact its power to reduce the discount rate in an effort to make borrowing more affordable for member banks.

When banks can borrow funds from the Fed at a less expensive rate, they are able to pass the savings to banking customers through lower interest rates charged on personal, auto, or mortgage loans. This creates an economic environment that encourages consumer borrowing and ultimately leads to an increase in consumer spending while rates are low.

Although a reduction in the discount rate positively affects interest rates for consumers wishing to borrow from banks, consumers experience a reduction in interest rates on savings vehicles as well. This may discourage long-term savings in safe investment options such as certificates of deposit (CDs) or money market savings accounts.

Increasing Interest Rates

When the economy is growing at a rate that may lead to hyperinflation, the Fed may increase interest rates. When member banks cannot borrow from the central bank at an interest rate that is cost-effective, lending to the consuming public may be tightened until interest rates are reduced again. An increase in the discount rate has a direct impact on the interest rate charged to consumers for lending products, and consumer spending shrinks when this tactic is implemented.

Although lending is not as attractive to banks or consumers when the discount rate is increased, consumers are more likely to receive more attractive interest rates on low-risk savings vehicles when this strategy is set in motion.

The Fed, like all central banks, uses interest rates to manage the macro-economy. Raising rates makes borrowing more expensive and slows down economic growth, while cutting rates encourages borrowing and investment on cheaper credit. All of this ripples out from the overnight lending rate that banks must utilize in order to maintain their required reserves of cash—which is also set by the Fed.

What Happens If Interest Rates Increase Too Quickly?

 When interest rates increase too quickly, it can cause a chain reaction that affects the domestic economy as well as the global economy. It can create a recession in some cases. If this happens, the government can backtrack the increase, but it can take some time for the economy to recover from the dip.

Central banks set target interest rates for an economy, which becomes the basis for all other interest rates on loans and debts, from car loans and mortgages to complex derivatives like credit default swaps.

Economic theory suggests that there is a balance between interest rates, unemployment, and inflation—if rates go too low, the economy can pick up but overheat leading to rising prices.

If rates rise too quickly, by the same token, borrowing becomes more expensive and the economy can grind to a halt.

More recent thinking by central bankers has led many to believe that raising rates too quickly is more of a risk than keeping them low for prolonged periods.

Understanding Interest Rates

Adjusting interest rates is one way that a central bank can encourage employment and keep prices stable in an economy. Interest rates have an impact on everything from home mortgage prices to the ability of a business to expand through financing. If interest rates go too high or are pushed higher than what people and companies can readily afford, spending could stop.

In this sense, higher interest rates could mean that a person may not be able to get a loan to purchase a house on favorable terms, or that a company will lay workers off instead of financing payroll during a downturn.

Looking for Balance

Raising interest rates can slow down the economy, bringing inflation with it, while lowering interest rates can encourage spending. Lowering interest rates is a powerful form of economic stimulus, but it cannot be overdone. The goal is to keep inflation around 2% per year for personal consumption expenditures, but it requires a careful balance.

Former Federal Reserve Chairwoman Janet Yellen (now U.S. Secretary of the Treasury under President Biden) has recently said that increasing interest rates too quickly often carries more risks than leaving them at lower levels for too long.

When Interest Rates Go Up

When the U.S. Federal Reserve raises the federal funds rate, the cost of borrowing goes up too, and this increase starts a series of cascading effects. In essence, banks raise their interest rates for consumers and businesses, and it costs more to buy a home or finance a company. In turn, the economy slows down as people spend less. However, this also keeps the cost of goods stable and curtails inflation. It serves as a signal that economic growth in the United States is expected to be firm as well.

Timing Is Everything

It all comes down to timing. The economy has to be robust enough to handle the increase in the cost of borrowing. If the Fed increases interest rates too quickly – before the economy is ready for it—the realized effect of the interest rate increase can be too much, and the measure could backfire. The economy would become strained and fall into a recession.

Moreover, the effect of interest rates going up would not only be felt in the U.S. If interest rates rise too quickly, the comparative value of the dollar could go up, affecting world markets as well as domestic companies with businesses in other countries.

The Impact Of Interest Rate Changes By The Federal Reserves

 On September 18, 2019, the Federal Reserve—also called the Fed—cut the target range for its benchmark interest rate by 0.25%. It was the second time the Fed had cut rates in 2019, and part of an ongoing attempt to keep the economic expansion from slowing amid many signs that a slowdown had already begun (and, in fact, was already well underway).1 Then, at the beginning of the global coronavirus pandemic in 2020, the Fed cut interest rates even further on March 15, 2020, in a dramatic move to near 0%.2

Why does the Fed cut interest rates when the economy begins to struggle—or raise them when the economy is booming? The theory is that by cutting rates, borrowing costs decrease, and this prompts businesses to take out loans to hire more people and expand production. The logic works in reverse when the economy is hot. Here, we take a look at the impact on various parts of the economy when the Fed changes interest rates, from lending and borrowing to consumer spending to the stock market.

When interest rates change, there are real-world effects on the ways that consumers and businesses can access credit to make necessary purchases and plan their finances. It even affects some life insurance policies. This article explores how consumers will pay more for the capital required to make purchases and why businesses will face higher costs tied to expanding their operations and funding payrolls when the Fed changes the interest rate. However, the preceding entities are not the only ones that suffer due to higher costs, as this article explains.

Central banks cut interest rates when the economy slows down in order to re-invigorate economic activity and growth.

The goal is to reduce the cost of borrowing so that people and companies are more willing to invest and spend.

Interest rate changes spill over to many facets of the economy, including mortgage rates and home sales, consumer credit and consumption, and stock market movements.

Interest Rates and Borrowing

Lower interest rates directly impact the bond market, as yields on everything from U.S. Treasuries to corporate bonds tend to fall, making them less attractive to new investors. Bond prices move inversely to interest rates, so as interest rates fall, the price of bonds rise. Likewise, an increase in interest rates sends the price of bonds lower, negatively impacting fixed-income investors. As rates rise, people are also less likely to borrow or re-finance existing debts, since it is more expensive to do so.

The Prime Rate 

A hike in the Fed's rate immediately fueled a jump in the prime rate (referred to by the Fed as the Bank Prime Loan Rate). The prime rate represents the credit rate that banks extend to their most credit-worthy customers. This rate is the one on which other forms of consumer credit are based, as a higher prime rate means that banks will increase fixed, and variable-rate borrowing costs when assessing risk on less credit-worthy companies and consumers. 

Credit Card Rates

Working off the prime rate, banks will determine how creditworthy other individuals are based on their risk profile. Rates will be affected for credit cards and other loans because both require extensive risk-profiling of consumers seeking credit to make purchases. Short-term borrowing will have higher rates than those considered long-term.

Savings 

Money market and certificate of deposit (CD) rates increase because of the tick-up of the prime rate. In theory, that should boost savings among consumers and businesses because they can generate a higher return on their savings. On the other hand, the effect may be that anyone with a debt burden would instead seek to pay off their financial obligations to offset the higher variable rates tied to credit cards, home loans, or other debt instruments.

U.S. National Debt 

A hike in interest rates boosts the borrowing costs for the U.S. government, fueling an increase in the national debt. A report from 2015 by the Congressional Budget Office and Dean Baker, a director at the Center for Economic and Policy Research in Washington, estimated that the U.S. government may end up paying $2.9 trillion more over the next decade due to increases in the interest rate, than it would have if the rates had stayed near zero. 3

Business Profits

When interest rates rise, its usually good news for banking sector profits since they can earn more money on the dollars that they loan out. But for the rest of the global business sector, a rate hike carves into profitability. That’s because the cost of capital required to expand goes higher. That could be terrible news for a market that is currently in an earnings recession. Lowering interest rates should be a boost to many businesses' profits as they can obtain capital with cheaper financing and make investments in their operations for a lower cost.

Auto Loan Rates

Auto companies have benefited immensely from the Fed’s zero-interest-rate policy, but rising benchmark rates will have an incremental impact. Surprisingly, auto loans have not shifted much since the Federal Reserve's announcement because they are long-term loans. In theory, lower interest rates on auto loans should encourage car purchases, but these big-ticket items may not be as sensitive as more immediate needs borrowing on credit cards.

Mortgage Rates

A sign of a rate hike can send home borrowers rushing to close on a deal for a fixed loan rate on a new home. However, mortgage rates traditionally fluctuate more in tandem with the yield of domestic 10-year Treasury notes, which are largely affected by interest rates. Therefore, if interest rates go down, mortgage rates will also go down. Lower mortgage rates mean it becomes cheaper to buy a home.

Home Sales

Higher interest rates and higher inflation typically cool demand in the housing sector. For example, on a 30-year loan at 4.65%, homebuyers can anticipate at least 60% in interest payments over the duration of their investment. But if interest rates fall, the same home for the same purchase price will result in lower monthly payments and less total interest paid over the life of the mortgage. As mortgage rates fall, the same home becomes more affordable—and so buyers should be more eager to make purchases.

Consumer Spending

A rise in borrowing costs traditionally weighs on consumer spending. Both higher credit card rates and higher savings rates due to better bank rates provide fuel a downturn in consumer impulse purchasing. When interest rates go down, consumers can buy on credit at lower cost. This can be anything from credit card purchases to appliances purchased on store credit to cars with loans.

Inflation

Inflation is when the general prices of goods and services rise in an economy, which may be caused by a nation's currency losing value or by an economy becoming over-heated—i.e. growing so fast that demand for goods is outpacing supply and driving up prices. When inflation rises, interest rates are often increased as well, so that the central bank can keep inflation in check (they tend to target 2% a year of inflation). If, however, interest rates fall, inflation can begin to accelerate as people buying on cheap credit can begin bidding up prices once again.

The Stock Market

Although profitability on a broader scale can slip when interest rates rise, an uptick is typically good for companies that do the bulk of their business in the United States. That is because local products become more attractive due to the stronger U.S. dollar. That rising dollar has a negative effect on companies that do a significant amount of business on the international markets. As the U.S. dollar rises—bolstered by higher interest rates—against foreign currencies, companies abroad see their sales decline in real terms. Companies like Microsoft Corporation, Hershey, Caterpillar, and Johnson&Johnson have all, at one point, warned about the impact of the rising dollar on their profitability. Rate hikes tend to be particularly positive for the financial sector. Bank stocks tend to perform favorably in times of rising hikes. 

Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions—as a general rule of thumb, when the Fed cuts interest rates, it causes the stock market to go up and when the Fed raises interest rates, it causes the stock market as a whole to go down. But there is no guarantee of how the market will react to any given interest rate change the Fed chooses to make.

When the economy falters, the central bank can step in to cut rates. The Federal Reserve is keen to react to rising inflation or recession using this tool to lower the cost of borrowing so that firms and households can spend more and invest - with the goal of keeping the economy chugging along smoothly.

How Interest Rate Cuts Affect Consumers

 The Federal Reserve's open market committee (FOMC) meets regularly to decide what, if anything, to do with short-term interest rates. Indeed, interest rates are closely watched by analysts and economists as these key figures play out in every asset market around the globe. Stock traders almost always rejoice when the Fed cuts interest rates, but does a rate cut equal good news for everyone? Rate cuts tend to favor borrowers, but hurt lenders and savers.

But what about ordinary households? Interest rate changes also have large impacts on consumer behavior and the level of consumption an economy can expect. This is because higher rates translate to larger borrowing and financing costs for things purchased on credit. Read on to find out exactly where this comes into play.

Interest rates have a direct effect on consumer behavior, impacting several facets of everyday life.

When rates go down, borrowing becomes cheaper, making large purchases on credit more affordable, such as home mortgages, auto loans, and credit card expenses.

When rates go up, borrowing is more expensive, putting a damper on consumption. Higher rates, however, do benefit savers who get more favorable interest on deposit accounts.

What Are Interest Rates?

When the Fed "cuts rates," this refers to a decision by the FOMC to reduce the federal fund's target rate. The target rate is a guideline for the actual rate that banks charge each other on overnight reserve loans. Rates on interbank loans are negotiated by the individual banks and, usually, stay close to the target rate. The target rate may also be referred to as the "federal funds rate" or the "nominal rate."

The federal funds rate is important because many other rates, domestic and international, are linked directly to it or move closely with it.

Why Do Rates Change?

The federal funds rate is a monetary policy tool used to achieve the Fed's goals of price stability (low inflation) and sustainable economic growth. Changing the federal funds rate influences the money supply, beginning with banks and eventually trickling down to consumers.

The Fed lowers interest rates in order to stimulate economic growth. Lower financing costs can encourage borrowing and investing. However, when rates are too low, they can spur excessive growth and perhaps inflation. Inflation eats away at purchasing power and could undermine the sustainability of the desired economic expansion.

On the other hand, when there is too much growth, the Fed will raise interest rates. Rate increases are used to slow inflation and return growth to more sustainable levels. Rates cannot get too high, because more expensive financing could lead the economy into a period of slow growth or even contraction.

 On August 27, 2020 the Federal Reserve announced that it will no longer raise interest rates due to unemployment falling below a certain level if inflation remains low. It also changed its inflation target to an average, meaning that it will allow inflation to rise somewhat above its 2% target to make up for periods when it was below 2%.2

Financing

The Fed's target rate is the basis for bank-to-bank lending. The rate banks charge their most creditworthy corporate customers is known as the prime lending rate. Often referred to as "the prime," this rate is linked directly to the Federal Reserve's target rate. Prime is pegged at 300 basis points (3%) above the target rate.3

Consumers can expect to pay prime plus a premium depending on factors such as their assets, liabilities, income, and creditworthiness.

A rate cut could help consumers save money by reducing interest payments on certain types of financing that are linked to prime or other rates, which tend to move in tandem with the Fed's target rate.

Mortgages

A rate cut can prove beneficial with home financing, but the impact depends on what type of mortgage the consumer has, whether fixed or adjustable, and which rate the mortgage is linked to.

For fixed-rate mortgages, a rate cut will have no impact on the amount of the monthly payment. Low rates can be good for potential homeowners, but fixed-rate mortgages do not move directly with the Fed's rate changes. A Fed rate cut changes the short-term lending rate, but most fixed-rate mortgages are based on long-term rates, which do not fluctuate as much as short-term rates.

Generally speaking, when the Fed issues a rate cut, adjustable-rate mortgage (ARM) payments will decrease. The amount by which a mortgage payment changes will depend on the rate the mortgage uses when it resets. Many ARMs are linked to short-term Treasury yields, which tend to move with the Fed or the London Interbank Offered Rate (LIBOR), which does not always move with the Fed. Many home-equity loans and home-equity lines of credit (HELOCs) are also linked to prime or LIBOR.

Credit Cards

The impact of a rate cut on credit card debt also depends on whether the credit card carries a fixed or variable rate. For consumers with fixed-rate credit cards, a rate cut usually results in no change. Many credit cards with variable rates are linked to the prime rate, so a federal funds rate cut will typically lead to lower interest charges.

It is important to remember that even if a credit card carries a fixed rate, credit card companies can change interest rates whenever they want to, as long as they provide advanced notice (check your terms for the required notice).

Savings Accounts

When the Fed cuts interest rates, consumers usually earn less interest on their savings. Banks will typically lower rates paid on cash held in bank certificates of deposits (CDs), money market accounts, and regular savings accounts. The rate cut usually takes a few weeks to be reflected in bank rates.

CDs and Money Market Accounts

If you have already purchased a bank CD, there is no need to worry about a rate cut because your rate is locked in. But if you plan to purchase additional CDs, a rate cut will result in new, lower rates.

Deposits placed into money market accounts (MMAs) will see similar activity. Banks use MMA deposits to invest in traditionally safe assets like CDs and Treasury bills, so a Fed rate cut will result in lower rates for money market account holders.

Money Market Funds

Unlike a money market account, a money market fund (MMF) is an investment account. While both pay higher rates than regular savings accounts, they may not have the same response to a rate cut.

The response of MMF rates to a rate cut by the Fed depends on whether the fund is taxable or tax-free (like one that invests in municipal bonds). Taxable funds usually adjust in line with the Fed, so in the event of a rate cut, consumers can expect to see lower rates offered by these securities.

Because of their tax-exempt status, rates on municipal money market funds already fall beneath their taxable counterparts and may not necessarily follow the Fed. These funds also may be linked to different rates, such as LIBOR or the Security Industry and Financial Markets Association (SIFMA) Municipal Swap Index.

Investments

If you have a 401(k) plan or a brokerage account, interest rates also directly impact your investment portfolio. Lower rates often are a boost to stocks (except, perhaps to financial sector stocks) but at the same time are a drag on bond prices. Lower rates also let investors with margin accounts take greater advantage of leverage at lower rates, increasing their effective purchasing power.

On the other hand, higher rates can pull stocks lower but increase the value of bonds. In general, longer-term bonds are more sensitive to interest rate changes than near-term bonds.

The Bottom Line

The Federal Reserve uses its target rate as a monetary policy tool, and the impact of a change to the target rate depends on whether you are a borrower or a saver. Read the terms of your financing and savings arrangements to determine which rates are relevant to you to determine exactly what the recent Fed cut means for your wallet.

How Interest Rates Affect Mutual Funds

 Changing interest rates impact a wide range of financial products, from bonds to bank loans. Mutual fund investments are no different, so a basic understanding of how interest rates work and how they can affect your portfolio is an important step in ensuring you invest in products that continue to generate healthy returns for years to come.

The Basics

The term "interest rate" is widely used to refer to the specific rate set by the Federal Reserve, or Fed. This rate is called the federal funds rate, but it is also commonly called the national rate. The federal funds rate is the interest rate banks charge other banks for very short-term loans, often just overnight. Because banks must close each day with a minimum amount of capital on reserve relative to the amount of money loaned out, a bank with surplus funds may lend the extra to a bank that comes up short so both banks can meet their capital quotas for the day. The federal funds rate dictates the interest the first bank charges the second bank for the privilege of borrowing cash.

This interest rate serves as the baseline for all other types of interest charges. For example, the discount rate is the rate at which banks may borrow money directly from the Fed, while the prime rate is the rate banks charge their most trustworthy borrowers. Changes in the fund rate directly impact both.

The effect of changing interest rates does not end with banks' internal finances, however. To offset the impact of these changes, banks pass the costs along to their borrowers in the form of mortgage rates, loan rates, and credit card interest rates. Though it is not required, it is very likely banks will raise their loan and credit rates if the funds rate increases. If the Fed reduces the funds rate, it becomes cheaper to borrow money in general.

Why Do Interest Rates Change?

The Federal Reserve raises and lowers the federal funds rate as a means of controlling inflation while still allowing the economy to thrive. If rates are too low, borrowing money becomes extremely cheap, allowing a rapid influx of cash into the economy, which in turn pushes up prices. This is called inflation, and it is the reason a movie ticket costs nearly $15 even though it cost only $10 a few years ago. Conversely, if interest rates are too high, borrowing money becomes too expensive, and the economy suffers as businesses are no longer able to fund growth and individuals are not able to afford mortgages or car loans.

Interest Rate Effect on Debt Securities

In the investment sector, bonds are the clearest example of the impact that changing interest rates can have on investment returns. Bonds are simply debt instruments issued by governments, municipalities, and corporations to generate funds. When an investor purchases a bond, she is loaning money to the issuing entity in exchange for the promise of repayment at a later date and the guarantee of annual interest payments. Much like the owner of a home mortgage must pay a set amount of interest to the bank each month to compensate for the risk of default, bondholders receive periodic interest payments, called coupon payments, over the life of the bond.

Just like other types of debt, such as loans and credit cards, changes in the funds rate directly impact bond interest rates. When interest rates rise, the value of previously issued bonds with lower rates decreases. This is because an investor looking to purchase a bond would not purchase one with a 4% coupon rate if she could buy a bond with a 7% rate for the same price. To encourage investors to purchase older bonds with lower coupon payments, the prices of these bonds decline. Conversely, when interest rates go down, the value of previously issued bonds rises because they carry higher coupon rates than newly issued debt.

This impact is mirrored in other types of debt securities, such as notes, bills, and corporate paper. In short, when the cost of interbank borrowing changes, it causes a ripple effect that impacts all other forms of borrowing in the economy.

Interest Rate Effect on Debt-Oriented Funds

When it comes to mutual funds, things can become a little complicated due to the diverse nature of their portfolios. However, when it comes to debt-oriented funds, the impact of changing interest rates is relatively clear. In general, bond funds tend to do well when interest rates decline because the securities already in the fund's portfolio likely carry higher coupon rates than newly issued bonds, and thus increase in value. If the Fed raises rates, however, bond funds may suffer because new bonds with higher coupon rates drive down the value of older bonds.

This rule holds true in the short term, at least. The value of a mutual fund investment is determined by its net asset value (NAV), which is the total market value of its entire portfolio divided, including any interest or dividends earned, by the number of shares outstanding. Because the NAV is based in part on the market value of the fund's assets, rising interest rates can have a serious impact on the NAV of a bond fund holding newly undesirable assets. If interest rates drop and older bonds begin trading at a premium, the NAV may jump significantly. For those looking to cash out mutual fund shares in the short term, interest rate changes can be either disastrous or delightful.

However, the life of a bond has a lot to do with how much of an effect interest rate changes have on its value. Bonds that are very near maturity, within a year, for example, are much less likely to lose or gain value. This is because, at maturity, the bond issuer must pay the full par value of the bond to whoever owns it. As the maturity date approaches, the market value of a bond converges with its par value. Bonds that have many years left until maturity, conversely, can be greatly impacted by changing rates.

Because of the stability of short-term debt, money market funds or other mutual funds that invest primarily in secure, short-term assets issued by highly rated governments or corporations are less vulnerable to the ravages of interest rate volatility. Similarly, buy-and-hold investors who own shares in long-term bond funds may be able to ride out the roller coaster ride of interest rate fluctuations as the market value of the portfolio converges with its total par value over time. In addition, bond funds can purchase newer, higher-interest bonds as older assets mature.

Do Rising Interest Rates Make Investing Less Attractive?

The impact of changing interest rates is clear when it comes to the profitability of debt-oriented mutual funds. However, rising interest rates may make mutual funds, and other investments, less attractive in general. Because the cost of borrowing increases as interest rates rise, individuals and businesses have less money to put into their portfolios. This means mutual funds have less capital to work with, making it harder to generate healthy returns. In addition, the stock market tends to take a dip when interest rates increase, which hurts shareholders of both individual stocks and stock-holding mutual funds.

Interest Rate Insurance

 Interest rate insurance protects the holder of a variable rate mortgage or loan from rising interest rates. It is generally offered independently of the original borrowing and typically as an alternative to a remortgage onto a fixed rate.

As the insurance policy protects only against the risk of the repayments rising because of interest rates (and not of the borrower defaulting on repayments) there is no requirement for the insurer to check the credit status of the purchaser or the value of any secured asset.

The absence of arrangement and valuation fees, bank and legal charges means that interest rate insurance can be cheaper to provide than a remortgage. The absence of credit checks and valuations means it can be made available to all holders of a variable rate loan.

As interest rate insurance protects the holder from rising interest rates but does not raise their initial pay rate, if interest rates fall, the policyholder will see a benefit in reduced payments on their mortgage or loan when compared to a fixed rate alternative.

History (UK)

Monetary Policy Committee member Professor David Miles first highlighted interest rate insurance in the Miles Review in 2004 commissioned by Gordon Brown. Professor Miles suggested that it would provide greater security in housing finance. In the 2008 Budget, HM Treasury announced that the industry was ready to launch such a product.

In July 2008 MarketGuard launched an interest rate insurance policy RateGuard.

How Interest Rates Affect the Insurance Sector

Interest rates are constantly fluctuating, with real-time market changes influencing the likelihood of any sweeping interest rate changes, as well. In fact, when it comes to interest rates and insurance, interest rate risk for insurance companies is a significant factor in determining profitability. Typically, if interest rates increase, the value of a bond or other fixed-income investment will decrease. Although rate changes in either direction may affect the normal operations of an insurance company, an insurer's profitability typically rises and falls in concert as interest rates increase or decrease.

Interest rates and insurance are deeply linked, meaning any changes in interest rates affect the profitability of the insurance sector in multiple ways.

Because many insurance companies tend to hold assets such as long-term bonds, when interest rates increase, the opportunity cost of holding bonds at a lower-rate over time also increases.

Historical analysis shows that the overall trend is for the insurance sector to increase profitability when there are rising interest rates.

Affecting a Change in Assets

For one, any changes in interest rates can affect the assets of an insurance company. Because insurance companies have substantial investments in interest-sensitive assets such as bonds, as well as market interest rate-sensitive products for their customers, they are especially susceptible to any changes in interest rates that could affect their profitability. For example, let's say an insurance company is holding a ten-year, $1000 bond with a 3% coupon rate. If interest rates rise to 5%, then the insurance company will ultimately lose out and have a harder time selling the bond. However, the reverse could also be true, if the insurance company has locked in a higher coupon rate but market interest rates end up falling.

In a nutshell, when interest rates increase, the opportunity cost of holding bonds over a long period of time also increases, meaning the cost of missing out on an even better investment is greater. 

Affecting a Change in Liabilities

Drops in interest rates can also decrease an insurance company's liabilities by decreasing its future obligations to policyholders. However, lower interest rates can also make the insurance company's products less attractive, resulting in lower sales and, thus, lower income in the form of premiums that the insurance company has available to invest. The net impact on the company's profitability is determined by whether the decrease in liabilities is greater or less than any reduction in assets that is experienced.

Additionally, lower interest rates can also negatively impact an insurance company's risk profile as an equity investment, if analysts ultimately believe that the company may have difficulty meeting future financial obligations. Lower levels of equity investment typically mean lower levels of assets for insurers.

While the precise effect of interest rate changes on a specific insurance company may be uncertain, historical analysis shows that the overall trend is for the profitability of the insurance sector to increase in an environment of rising interest rates. Overall price-to-earnings (P/E) ratios for insurance company stocks usually increase in fairly direct proportion to increases in interest rates.

Tuition Insurance

 Tuition insurance is an insurance protecting students attending cost-intensive educational institutions - schools, colleges or universities - from the financial loss that may result from the student’s involuntary withdrawal from his or her studies. It usually covers withdrawals due to medical reasons and the death of the student’s legal guardians by either refunding or covering the costs associated with attending the student’s institution. Tuition insurance may also cover student loans.

Tuition insurance can be obtained through educational institutions or directly from an insurance provider. It can also be obtained as part of a student loan. Most tuition insurance policies cover the cost of tuition in whole or partly if a student has to withdraw from his or her studies due to medical reasons; however, this may be limited to the first weeks of the semester. If the withdrawal is due to mental health reasons the reimbursement rarely exceeds 60%.

Tuition insurance has existed since 1930. It benefits both students and educational institutions since it may cover the money a student owes an educational institution in case the tuition payer can no longer cover these costs.

If offered for elementary or secondary school it often pays if a parent loses a job or the student has to leave school due to illness or a move. This is more comprehensive than policies for college tuition, which cover only a withdrawal due to the student medical or mental health illness. Premiums can range from 1-3 percent of tuition per semester. About 170 colleges and universities offer the insurance at this time.

If you are paying for a high-priced K-12 education this type of insurance might be valuable, especially if you feel you might be facing a layoff or transfer. The college plans, because they are restricted to illness, don't seem to be as easy to assess. Most young adults who are healthy probably run a small risk of needing this coverage. However the peace of mind it provides to the parent who is writing the tuition check may be worth millions.

Title Insurance

 Title insurance is a form of indemnity insurance predominantly found in the United States and Canada which insures against financial loss from defects in title to real property and from the invalidity or unenforceability of mortgage loans. Unlike some land registration systems in countries outside the United States, US states' recorders of deeds generally do not guarantee indefeasible title to those recorded titles. Title insurance will defend against a lawsuit attacking the title or reimburse the insured for the actual monetary loss incurred up to the dollar amount of insurance provided by the policy.

The first title insurance company, the Law Property Assurance and Trust Society, was formed in Pennsylvania in 1853. Typically the real property interests insured are fee simple ownership or a mortgage. However, title insurance can be purchased to insure any interest in real property, including an easement, lease, or life estate.

There are two types of policies – owner and lender. Just as lenders require fire insurance and other types of insurance coverage to protect their investment, nearly all institutional lenders also require title insurance to protect their interest in the collateral of loans secured by real estate. Some mortgage lenders, especially non-institutional lenders, may not require title insurance. Buyers purchasing properties for cash or with a mortgage lender often want title insurance as well.

A loan policy provides no coverage or benefit for the buyer/owner and so the decision to purchase an owner policy is independent of the lender's decision to require a loan policy.

Title insurance is available in many other countries, such as Canada, Australia, the United Kingdom, Mexico, New Zealand, Japan, China, South Korea, and throughout Europe. However, while a substantial number of properties located in these countries are insured by U.S. title insurers, they do not constitute a significant share of the real estate transactions in those countries. They also do not constitute a large share of U.S. title insurers' revenues. In many cases these are properties to be used for commercial purposes by U.S. companies doing business abroad, or properties financed by U.S lenders. The U.S. companies involved buy title insurance to obtain the security of a U.S. insurer backing up the evidence of title that they receive from the other country's land registration system, and payment of legal defense costs if the title is challenged.

History

Prior to the invention of title insurance, buyers in real estate transactions bore sole responsibility for ensuring the validity of the land title held by the seller. If the title were later deemed invalid or found to be fraudulent, the buyer lost his investment.

In 1868, the case of Watson v. Muirhead was heard by the Pennsylvania Supreme Court. Plaintiff Watson had lost his investment in a real estate transaction as the result of a prior lien on the property. Defendant Muirhead, the conveyancer, had discovered the lien prior to the sale but told Watson the title was clear after his lawyer had (erroneously) determined that the lien was not valid.

The courts ruled that Muirhead (and others in similar situations) was not liable for mistakes based on professional opinions. As a result, in 1874, the Pennsylvania legislature passed an act allowing for the incorporation of title insurance companies.

Joshua Morris, a conveyancer in Philadelphia, and several colleagues met on March 28, 1876 to incorporate the first title insurance company. The new firm, Real Estate Title Insurance Company of Philadelphia, would "insure the purchasers of real estate and mortgages against losses from defective titles, liens and encumbrances," and that "through these facilities, transfer of real estate and real estate securities can be made more speedily and with greater security than heretofore."

Morris' aunt purchased the first policy, valued at $1,500, to cover a home on North 43rd Street in Philadelphia.

Purpose

There are two types of title systems used worldwide: Land registration and land recording.

Most of the industrialized world uses land registration systems for the transfer of land titles or interests in them. Under these systems, the government determines title ownership and encumbrances using its land registration; with only a few exceptions, the government's determination is conclusive. Governmental errors lead to monetary compensation to the person damaged by the error but that aggrieved party usually cannot recover the property. The Torrens title system is the basis for land registration systems in several common law countries. Nineteen jurisdictions in the United States, such as Minnesota and Massachusetts, adopted a form of this system between 1896 and 1917, however it fell out of favor after a single judgement in Imperial County, California, bankrupted the state's title indemnification fund[citation needed], and the vast majority of U.S. states have opted for a system of document recording in which no governmental official makes any determination of who owns the title or whether the instruments transferring it are valid.

In the recording system, each time a land title transaction takes place, the parties record the transfer instrument with a local government recorder located in the jurisdiction (usually the county) where the land lies. The government indexes the instrument by the names of the grantor (transferor) and the grantee (transferee) and photographs it so any member of the public can find and examine it. If such a transaction goes unrecorded for any reason or length of time, an unscrupulous grantor could sell the property to another grantee. In many states, the grantee whose transaction is recorded first becomes the legal owner, and any other would-be buyers are left without recourse.

The advantage of the recording system is:

In a registration system, the cost and risk are borne by the general public, but in a recording system, cost and risk are borne by the users of the system.

In a recording system, an independent authority reviews government land transfers. In a registration system government can decide registration disputes in its favor, preventing separation of powers and the constitutional right to due process of law.

A recording system can provide for conveyance of land for situations beyond the capacity of public records, such as homesteading and inheritance.

A recording system combined with title insurance decentralizes records, creating redundancy. For example, when many records were destroyed in San Francisco's 1906 earthquake, out-of-town title companies maintained records that allowed landowners to prove ownership of their property.

Under this system, to determine who has title, one must:

Examine the indexes in the recorders' offices, pursuant to various rules established by state legislatures and courts.

Scrutinize the recorded instruments.

Determine how they affect the title under applicable law. The final arbiters of title matters are the courts, which make decisions in suits brought by disagreeing parties. Historically, the person who wanted to understand the title would hire an abstractor to write a property abstract showing the chain of title. However, if the abstractor makes an error, the client may only be compensated if the attorney is negligent, subject to the limit of his financial responsibility (including his liability insurance). However, the willingness of these professionals to accept strict liability varies.

Title insurers conduct a title search on public records before they agree to insure the purchaser or mortgagee of land. Specifically, after a real estate sales contract has been executed and escrow opened, a title professional will search the public records to look for any problems with the home's title. This search typically involves a review of land records going back many years. More than one-third of all title searches reveal a title problem that title professionals will insist on fixing before the transaction closes. For instance, a previous owner may have had minor construction done on the property, but never fully paid the contractor (resulting in a mechanic's lien), or the previous owner may have failed to pay local or state taxes (resulting in a tax lien). Title professionals seek to resolve problems like these before the transaction closes, since otherwise, their employer, the title insurer, will be required to fix such title defects by paying such unpaid fees or taxes.

Title insurance policies are fairly uniform, and backed by statutory reserves, which is especially important in large commercial real estate transactions where the buyer and their lender have a large amount of money at stake. The insurer also pays for the defense of its insured in legal contests.

At least 20 U.S. states have experimented with Torrens title or other title registration systems at one time or another, but most have retreated to title recording under pressure from title insurers or from lack of interest. According to Karl Llewellyn, one Torrens title on one lot in New York City can render the entire block unavailable for large-scale improvement (i.e., skyscrapers); no lender will finance the purchase of such a lot because no New York title insurer will guarantee a Torrens title. The U.S. title insurance industry has successfully opposed land registration systems by saying that they are vulnerable to fraud (a severe problem in most land registration jurisdictions) and that an inherently contingent property system more effectively protects property rights. While it is possible to fortify land registration systems to prevent the registration of forged deeds, the necessary countermeasures are complex and expensive. A 2007 book attacking the American title insurance "cartel" acknowledged that "more extensive use of Torrens certification would require setting up a special judicially supervised bureaucracy."

Types of policies

Standardized forms of title insurance exist for owners and lenders. The lender's policies include a form specifically for construction loans, though this is rarely used today.

Owner's policy

The owner's policy assures a purchaser that the title to the property is vested in that purchaser and that it is free from all defects, liens and encumbrances except those listed as exceptions in the policy or are excluded from the scope of the policy's coverage. It also covers losses and damages suffered if the title is unmarketable. The policy also provides coverage for loss if there is no right of access to the land. Although these are the basic coverages, expanded forms of residential owner's policies exist that cover additional items of loss.

The liability limit of the owner's policy is typically the purchase price paid for the property. As with other types of insurance, coverages can also be added or deleted with an endorsement. There are many forms of standard endorsements to cover a variety of common issues. The premium for the policy may be paid by the seller or buyer as the parties agree. Usually a custom in a particular state or county on this matter reflects in most local real estate contracts. One should inquire about the cost of title insurance before signing a real estate contract that provides that he pay for title charges. A real estate attorney, broker, escrow officer (in the western states), or loan officer can provide detailed information as to the price of title search and insurance before the real estate contract is signed. Title insurance coverage lasts as long as the insured retains an interest in the land insured and typically no additional premium is paid after the policy is issued.

Lender's policy

This is sometimes called a loan policy and it is issued only to mortgage lenders. Generally speaking, it follows the assignment of the mortgage loan, meaning that the policy benefits the purchaser of the loan if the loan is sold. For this reason, these policies greatly facilitate the sale of mortgages into the secondary market. That market is made up of high volume purchasers such as Fannie Mae and the Federal Home Loan Mortgage Corporation as well as private institutions.

The American Land Title Association ("ALTA") forms are almost universally used in the country though they have been modified in some states. In general, the basic elements of insurance they provide to the lender cover losses from the following matters:

The title to the property on which the mortgage is being made is either

• Not in the mortgage loan borrower,
• Subject to defects, liens or encumbrances, or
• Unmarketable.

There is no right of access to the land.

The lien created by the mortgage:

• is invalid or unenforceable,
• is not prior to any other lien existing on the property on the date the policy is written, or
• is subject to mechanic's liens under certain circumstances.

As with all of the ALTA forms, the policy also covers the cost of defending insured matters against attack.

Elements 1 and 2 are important to the lender because they cover its expectations of the title it will receive if it must foreclose its mortgage. Element 3 covers matters that will interfere with its foreclosure.

Of course, all of the policies except or exclude certain matters and are subject to various conditions.

There are also ALTA mortgage policies covering single or one-to-four family housing mortgages. These cover the elements of loss listed above plus others. Examples of the other coverages are loss from forged releases of the mortgage and loss resulting from encroachments of improvements on adjoining land onto the mortgaged property when the improvements are constructed after the loan is made.

Construction loan policy

In many states, separate policies exist for construction loans. Title insurance for construction loans require a Date Down endorsement that recognizes that the insured amount for the property has increased due to construction funds that have been vested into the property.

Land title associations and standardized policies

In the United States, the American Land Title Association (ALTA) is a national non-profit trade association representing the interests of nearly 4,500 title insurance companies, title agents, independent abstracters, title searchers and attorneys across the United States. ALTA members conduct title searches, examinations, closings, and issue title insurance that protects real property owners and mortgage lenders against losses from defects in titles.

Founded in 1907, ALTA has created standard forms of title insurance policy "jackets" (standard terms and conditions) for Owners, Lenders and Construction Loan policies. ALTA forms are used in most, but not all, U.S. states. ALTA also offers special endorsement forms for the various policies; endorsements amend and typically broaden the coverage given under a basic title insurance policy. ALTA does not issue title insurance; it provides standardized policy and endorsement forms that most title insurers issue.

Some states, including Texas and New York, may mandate the use of forms of title insurance policy jackets and endorsements approved by the state insurance commissioner for properties located in those jurisdictions, but these forms are usually similar or identical to ALTA forms.

In addition to ALTA, the National Association of Independent Land Title Agents (NAILTA) is a national non-profit trade association that represents the interests of independent title insurance agents and independent real estate settlement professionals from across the United States. It was created by independent real estate settlement professionals to further the agenda of small business owners from within the title insurance, abstracting, surveying, and real estate community who lack representation at local, state and national levels. NAILTA is a national trade association that serves thousands of independent title and real estate professionals across the United States who collectively comprise over 60% of the national title insurance market, and identify themselves as independent settlement service providers. NAILTA represents the interests of those independent settlement service providers who serve over 31 million real estate purchase consumers per year, who close an estimated $514.8 billion's worth of refinance mortgages per year, and who collectively insure approximately $1.67 trillion in total national title insurance liability per year.

Comparison with other forms of insurance

Title insurance differs in several respects from other types of insurance. Where most insurance is a contract where the insurer indemnifies or guarantees another party against a possible specific type of loss (such as an accident or death) at a future date, title insurance generally insures against losses caused by title problems that have their source in past events. This often results in the curing of title defects or the elimination of adverse interests from the title before a transaction takes place. Title insurance companies attempt to achieve this by searching public records to develop and document the chain of title and to detect known claims against or defects in the title to the subject property. If liens or encumbrances are found, the insurer may require that steps be taken to eliminate them (for example, obtaining a release of an old mortgage or deed of trust that has been paid off, or requiring the payoff, or satisfying involuntary liens such as abstracts of judgment and tax liens) before issuing the title policy. Title insurance companies also have the ability to discharge ancient mortgages under the Real Property Actions and Proceedings Law (RPAPL) in New York. Ancient mortgages are ones that are presumed to be satisfied or complete and have been for over 20 years. In the alternative, it may except from the policy's coverage those items not eliminated. Title plants are sometimes maintained to index the public records geographically, with the goal of increasing searching efficiency and reducing claims. In some states title plants are required to index the real-property records geographically and also maintain a name file for judgments, probates and other general matters.

The explanation above discloses another difference between title insurance and other types: title insurance premiums are not principally calculated on the basis of actuarial science, as is true in most other types of insurance. Instead of correlating the probability of losses with their projected costs, title insurance seeks to eliminate the source of the losses through the use of the recording system and other underwriting practices. As a result, a relatively small fraction of title insurance premiums are used to pay insured losses. The great majority of the premiums is used to finance the title research on each piece of property and to maintain the title plants used to efficiently do that research. There is significant social utility in this approach as the result conforms with the expectations of most property purchasers and mortgage lenders. Generally, they want the real estate they purchased or lent money on to have the title condition they expected when they entered the transaction, rather than money compensation and litigation over unexpected defects. This is not to say that title insurers take no actuarial risks. There are several matters that can affect the title to land that are not disclosed by the recording system but that are covered by the policies. Some examples are deeds executed by minors or mentally incompetent persons, forged instruments (in some cases), corporate instruments executed without the proper corporate authority and errors in the public records. However, historically, these problems have not amounted to a high percentage of the losses paid by the insurers. A more significant percentage of losses paid by the insurers are the result of errors and omissions in the title examining process itself.

Homeowner's right to choose a title insurance company

In an April 2007 United States Government Accountability Office (GAO) Report on Title Insurance, the GAO recommended that state and federal legislators and regulators improve consumers ability to shop for title insurance based on price, encourage price competition, and ensure consumers are paying reasonable prices for title insurance.

A federal law called the Real Estate Settlement Procedures Act (RESPA) entitles an individual homeowner to choose a title insurance company when purchasing or refinancing residential property. Typically, homeowners do not make this decision for themselves and instead rely on their bank's or attorney's choice; however, the homeowner retains the right to choose a different insurer. RESPA makes it unlawful for any bank, broker, or attorney to mandate that a particular title insurance company be used. Doing so is a violation of federal law and any person or business doing so can be fined or lose its license.

Section 9 of RESPA prohibits a seller from requiring the buyer to use a particular title insurance company, either directly or indirectly, as a condition of sale. Buyers may sue a seller who violates this provision for an amount equal to three times all charges made for the title insurance. The only exception to this rule applies to commercial real estate transactions, which is not within the parameters of RESPA.

The new Loan Estimate form (LE) is the latest step taken by Department of Housing and Urban Development (HUD) to protect and assist consumers. In the past, lenders had provided potential borrowers with Good Faith Estimates (GFEs).

1. Lenders must issue the LE within three business days of loan application. However, many will provide the form to borrowers who are still in the shopping phase. Note that the LE provides more protections for consumers than a "worksheet" or "scenario" because lenders must by law adhere to its costs and indicate how long that rate and fee will be in effect.

If a loan originator does not provide the LE within 3 business days of receiving a completed loan application, it is in violation of Section 5 of RESPA. HUD provides the specific criteria for what constitutes a complete loan application:

• Borrower's name
• Borrower's monthly income
• Borrower's Social Security number (SSN) (to obtain a credit report)
• Property address
• The estimated value of the property
• Loan amount
• Anything else the lender deems necessary

2. The new LE is standardized

All lenders must provide consumers with the exact same document. Loan charges, third-party fees, and other costs must be displayed uniformly.

3. The new LE encourages consumers to shop

Since lenders are now required to issue a standardized LE in a specific time frame, consumers are provided an opportunity to compare lenders and their products. Further, HUD states that prior to the issuance of a LE, lenders can only charge potential borrowers a fee to cover the expense of a credit report. The relative low cost of credit reports ($15–30) results in consumers' ability to comparison shop many lenders at a minimal cost.

4. Lenders are accountable for their quotes

The new LE form puts the most important facts about a mortgage on the first page instead of burying them in small print throughout the form. This information includes:

• Loan amount, interest rate, and principal and interest payment.
• The existence of prepayment penalties, negative or balloon payments
• It alerts the borrower if the interest rate, loan balance or payment can increase during the loan's term
• Projected payments in future years, based on current financial indexes (mostly applies to adjustable rate mortgages (ARMs)
• Estimated escrows (also called impounds), which are payments for property taxes and homeowners insurance added to the monthly payment. the lender then pays these amounts on behalf of the borrower when they come due
• Total closing costs and cost to close (how much the borrower must bring to the closing)

5. At the closing, lenders must issue a Closing Disclosure (CD) disclosing the actual costs. The borrower can compare the actual costs to the estimated costs. Costs fall into several categories, and differences between the actual and estimated costs are treated accordingly:

a. 0% Tolerance. 

If at the closing, any item in the 0% Tolerance category is higher on the corresponding section of the CD compared to the original LE, the lender is responsible for covering the difference.

b. 10% Tolerance. 

Unlike the 0% Tolerance category, these items are not compared individually to their corresponding section in the CD. Instead, all items in the category are aggregated on the LE and compared to the aggregated corresponding items on the CD. In the event that the CD has a total more than 10% higher than the total on the LE, the lender is responsible for any expense in excess of the 10% increase. This means that individual items in the 10% Tolerance category may increase more than 10% from the LE to the CD without a penalty to the lender, as long as the sum of all the items does not increase more than 10%.

c. No Tolerance. 

A few sections of the new LE fall into the No Tolerance category. These quotes can change with no penalty to the lender.

Again, depending on the state, region, and vendor, homeowners can save substantial money by shopping around for title insurance except in some states, such as Texas, in which the rates are codified by law. In light of the changes made by RESPA and those to the LE, notable consumer and business publications have featured articles about the benefits of shopping around for title insurance, such as The Wall Street Journal, Kiplinger's Personal Finance, HSH.com, Forbes.com, and The New York Times.

Affiliated business arrangements

Sometimes, several businesses that offer settlement services are owned or controlled by a common corporate parent. These businesses are known as "affiliates", while the relationship is called an affiliated business arrangement (ABA).

When a lender, real estate broker, or other participant refers his homebuyer to an affiliate for a settlement service (such as when a real estate broker refers his homebuyer to a mortgage broker affiliate), the law requires the referring party to provide an affiliated business arrangement disclosure. This disclosure informs homebuyers they are not required to use the affiliate and are free to shop for other providers.

Despite advances in technology that allow homebuyers to shop for title services, many homebuyers remain unaware that they may select their own title insurance or settlement company.

A recent survey from the Ohio Association of Independent Title Agents (OAITA), conducted from 2009 through 2010, showed when homebuyers are made fully aware of ABAs, they become uncomfortable and prefer a title company or title agent to be a third party (i.e., independent) to the transaction.

While 77% of respondents did not independently select their settlement company, when made fully aware of the ABA relationships 50% of respondents said they prefer a title company that does not share profits with a referral source compared to 6% of respondents saying they prefer a title agent that shares profits with a referral source. Further, 58% of respondents said they believe that ABAs are a conflict of interest.

The OAITA stands in stark contrast to two Harris Interactive surveys used by the Real Estate Services Providers Council in a January 2011 meeting with Federal Reserve staff to claim that homebuyers were more satisfied with the ABA settlement service providers.

A 2002 study used by the proponents revealed that 64% of homebuyers who used "one-stop shopping" programs had a better overall experience with their home purchase transaction.

A 2008 study revealed that homebuyers who used "one-stop shopping" in their latest real estate transaction were more satisfied with their home buying experience compared to those who used services of multiple providers.

Organizations such as the National Association of Independent Land Title Agents seek to restore transparency and credibility to the land title process and to preserve an objective and impartial role at the closing table to improve the consumer experience, by addressing the proliferation of controlled business arrangements and eliminating conflicts of interest between title agents and their referral sources, as well as between all real estate settlement service providers and their sources of business.

Cost of title insurance

The cost of title insurance has two components: premium charges and service fees.

Title insurance premium rates are based on five cost considerations, including those related to:

• Maintaining current title information on property local to that operation, i.e., title plant
• Searching and examining the title to subject properties
• Resolving or clearing defects to title
• Covering title defects
• Allowing for a reasonable profit
• Premium charges

Like the rates for other forms of insurance, rates for title insurance usually are regulated by state governments to ensure that premiums are not excessive, inadequate or unfairly discriminatory to the public. States have different methods of regulating title insurance rates. The types of rate regulation used include:

Promulgation: State regulatory body sets the rates. An example is Texas, where rates are set after comprehensive hearings each year.

Prior approval: Insurers propose rates, which must be reviewed formally and approved explicitly or deemed approved by the regulatory body before they can be charged.

File and use: Insurers set rates, but they cannot be charged until the regulator has been notified and allowed time to review and action, if necessary. In some prior-approval states, almost the same result is achieved through a so-called deemer provision. Under a deemer, rates proposed by insurers are deemed approved if the regulatory body takes no action to disapprove a filing within a specified time, and the filer notifies the state that the rates are being deemed approved.

Use and file: Insurers set rates that can be charged immediately, as long as the new rate schedule is filed with the regulatory body.

No direct rate regulation: Insurers set rates that can be changed at an insurer's discretion. Even in this apparent unregulated situation, a regulatory body still is charged with overseeing the title insurance industry and can question the propriety of a rate that appears to be unfairly discriminatory or otherwise violates statutory standards. Examples are Illinois, Georgia and Massachusetts.

The rates may include discounts if title insurance is ordered within a specified time after the last policy issued or if the mortgage being insured is a refinance of an earlier mortgage. In the states employing any of these regulations, it is illegal for title insurance companies to charge a higher or lower rate than the regulated rate.

For example: In Pennsylvania there are two rates, basic rate and reissue rate. The basic rate would apply if it has been more than ten years since the last policy was issued. If less than ten years, the reissue rate applies. The reissue rate offers a discount of approximately ten percent off of the basic rate. If the transaction is a refinance, the savings can be as much as thirty percent off of the reissue rate. These rates and applicable discounts are filed with and approved by the Pennsylvania Insurance Commission.

Title insurance is substantially different from other lines of insurance because it emphasizes risk prevention rather than risk assumption. This means the majority of the premium dollar, about 80 percent, covers the work performed by title professionals, such as the search examination, curative work, policy issuance and, frequently, the settlement or closing. The remaining 20 percent covers the insurance policy, a significant portion of which is put into reserves for claims that could occur 10 or 20 years in the future. According to a 2006 survey by ALTA, title problems that required curative action were found in 36 percent of all residential real estate transactions in 2005. This was up from 25 percent in 2000, due to the booming real estate market and an increase in transactions.

Service fees

In some states, the regulated premium charge does not include part of the underwriting costs necessary for the process. In those states, title insurers may also charge search or abstracting fees for searching the public records, or examination fees to compensate them for the title examination. These fees are usually not regulated and in those cases may sometimes be negotiated. In some states, regulation requires that the title insurer base its policy on the opinion of an attorney. The attorney's fees are not regulated. They are also not part of the title insurance premium, though the title insurer may include those fees within its invoice as a convenience to the attorney rendering the opinion. Similarly, fees for closing a sale or mortgage transaction are not regulated in most states though the charge for closing may appear in the invoice disclosing the total charges for the transaction.

Industry profitability

The title industry is highly dependent on real estate markets, which, in turn, are highly sensitive to mortgage interest rates and the overall economic well-being. During the housing bubble from 2000 through 2006, the industry's revenue more than doubled. As the surge in real estate transactions drove up title insurance revenue—along with a greater incidence of claims—the economic downturn that started in 2007 pared back revenue significantly for several years. To compare, the industry reported nearly $17 billion in title insurance premiums in 2005, but volume fell to $9.6 billion in 2009.

In 2012, according to ALTA, the industry paid out about $908 million in claims, about 8.1% percent of the $11.2 billion taken in as premiums. By comparison, the boiler insurance industry, which like title insurance requires an emphasis on inspections and risk analysis, pays 25% of its premiums in claims. As mentioned above, professionals in the land title industry seek to prevent claims through up-front preventive measures before a policy is issued and therefore the industry's claims ratio is different from other lines of insurance.

According to the statutory accounting rules for title insurance, only reported claims are reflected in the loss expense, while in other lines—both reported and unreported claims are included in the loss expense. As a result, timing differences occur in the reporting of losses and loss-adjustment expenses for title insurance when compared to other lines. In addition, title insurance, unlike most other property/casualty exposures, has no termination date and no time limitation on filing claims.

In many states, the price of title insurance is regulated by a state insurance commission. In these states, the title insurance companies lobby state legislators and other politicians and donate to their campaigns, in the hopes of maintaining the rates high. Unlike other forms of insurance (such as life, medical, or home owners), title insurance is not paid for annually, as it has one payment for the term of the policy, which is in effect until the property is resold or refinanced.