Financial firms use various types of indexes to track average returns on bonds and other types of securities as well as to track interest rates charged by lenders for business and consumer loans. The current index value represents the average rate being paid on securities or loans listed on a particular index at a specific point in time. Economists track indexes to gauge the overall health of the economy within a particular region or nation.
In many countries, consumer mortgages are pooled into investment funds; bonds tied to these funds are sold to investors. Like mortgages, government bonds are debt securities and investors compare the yield paid on mortgage funds with the yield being paid on long-term government bonds. Generally, governmental entities are viewed as low risk borrowers when compared with homeowners. Consequently, mortgage rates must be higher than the rates being paid on government bonds; otherwise, investors would have no incentive to buy these funds rather than buying government issued debts. Lenders typically set mortgage rates at a certain margin above the current index value of indexes that track domestic government bond rates.
Aside from fixed-rate loans, variable-rate loans are also impacted by the current index value of various government bond indexes. The interest rate on a fixed-rate loan is dependent upon the average bond rate at the time the loan is issued. With variable-rate loans, lenders set the interest rate at a particular margin to the average index value. When the bond index rises, the loan rate rises in conjunction with it, while the opposite occurs when bond interest rates start to decline. Different lenders review indexes and alter the rates on variable-rate loans at monthly, annual or multi-year intervals.
Banks normally pay fixed rates of interest on deposit products but some banks use variable rates that are based on indexes. On 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 indexes that track the performance of the stock market. These banks make pay monthly returns if certain stocks on a particular index increase in value during a particular period of time. Conversely, banks often pay nothing to deposit holders if the securities listed on a particular index lose value during a CD term.
Economists use government bond indexes and similar performance indicators to predict future activity levels in the housing market. If bond indexes rise, loans become more expensive and this makes financing residential property more costly. Additionally, these price hikes can have knock-on effects that cause inflation across the entire economy. Therefore, an economist can make a prediction about an upcoming recession or economic boom based in part on the current index value of various charts that track the performance of bonds and securities.
