Lending Perspective

Matt Garrity says declining interest rates are typically good for the consumer and good for business.

The Federal Reserve’s decisions to lower its federal funds rate by a quarter-point in September, then another quarter-point in late October — landing at 3.75% — were good news to consumers and borrowers.

“A declining interest rate is good for the consumer and good for business; a business that’s borrowing on a regular basis for working capital can enjoy lower costs from that,” said Matt Garrity, president of Florence Bank. “A higher rate is more difficult for consumers.”

But the story is more complicated than that for banks themselves. The interest rate environment tends to be a mixed bag for financial institutions, impacting their core profitability, demand for loans, and the value of their balance sheets.

The primary mechanism for this calculation is net interest margin, the difference between the interest income banks earn on assets (loans and securities) and the interest expense they pay on liabilities (deposits and borrowed funds).

In a rising interest rate environment, banks’ profitability often increases, particularly in the short term. They can increase the interest rates they charge on new variable-rate loans more quickly than they raise the interest rates they pay on customer deposits, which widens the net interest margin. Meanwhile, yields on new loans and short-term securities increase, boosting overall interest income.

“When there’s a lot of volatile movement, like a couple of years ago, when the rates went up 400 basis points in a very short time, that causes a lot of problems because the market is moving too fast, and it’s hard for banks to rightsize, and it usually causes volatility on the lending side of things.”

At the same time, however, as borrowing becomes more expensive, consumers and businesses may be less willing to take out new loans for major purchases, which can slow loan growth.

Conversely, in a falling interest rate environment, bank profitability tends to be challenged, especially over the medium to long term. The rates banks earn on new and existing variable-rate assets fall faster than the rates they can cut on deposits, squeezing net interest margins.

“Banks are impacted in different ways when the Fed reduces interest rates. Most banks use the Federal Home Loan Bank, which borrows based on fed fund rates, so as the Fed reduces rates, those costs go down for banks,” Garrity said, while revenue falls for variable-rate loans.

Meanwhile, borrowers are more likely to refinance existing high-interest loans into new, lower-interest loans, which reduces the bank’s expected interest income on its existing portfolio.

However, lower interest rates make borrowing cheaper, which encourages consumer spending and business investment, increasing the volume of loans and potentially offsetting some of the margin pressure. “Certain investments make more sense with the lower rate,” Garrity said.

PeoplesBank President Brian Canina noted that, “when the Fed adjusts rates, it has a more immediate impact on deposit rates. On the loan side, it’s typically based off of a long-term rate. For example, a 30-year fixed rate more typically correlates with a 10-year treasury rate. There are some exceptions to that with credit cards and some home equity lines of credit; those are going to be more tied to the fed funds rate. But for the most part, when there’s a spread between the fed funds rate and the 10-year point of the treasury curve, that’s what drives profitability for the bank.”

Whether interest rates are high or low, Brian Canina says, what bankers are looking for is stability.

What banks don’t like, he said, is a situation in which short-term rates rise faster than long-term rates, causing a flattened or inverted yield curve, which is what happened when rates shot up in 2022. “Banks were challenged by these underwater rates, but over time things normalize, and profitability comes back.”

Essentially, Canina added, what bankers are really looking for is stability in the interest rate environment.

“When there’s a lot of volatile movement, like a couple of years ago, when the rates went up 400 basis points in a very short time, that causes a lot of problems because the market is moving too fast, and it’s hard for banks to rightsize, and it usually causes volatility on the lending side of things. Essentially, more of a stable environment in interest rate changes, whether that be increases or decreases, and maintaining a steepness in the yield curve is ideal for a banker.”

Home Sweet Home

Interestingly, mortgage rates rose in the wake of both Fed fund cuts, jumping from 6.13% to 6.33% in the hours around the Oct. 29 Fed meeting. The reason is that the bond market had already priced in a cut, and commentary from Fed Chair Jerome Powell tamped expectations for another rate cut in December.

In fact, typically, when a fed funds rate cut is anticipated, mortgage rates usually fall in the weeks leading up to the meeting, but don’t necessarily continue to decrease afterward. In 2024, mortgage rates fell sharply throughout August and early September as people expected the Fed to lower its rate at its September meeting, but they stopped decreasing significantly after the meeting, a trend repeated after two additional rate cuts later that year and, as noted, twice again in recent weeks.

Mortgage rates remain problematic for a number of reasons.

“Folks who are currently paying a lower interest rate don’t want to give that up for what could be a higher rate, which causes lower inventory — people are not putting their homes on the market, and that impacts affordability.”

“We’ve seen, across the country and in our region in the last few years, how it’s impacted folks and led to lower inventory on the market because folks who are currently paying a lower interest rate don’t want to give that up for what could be a higher rate, which causes lower inventory — people are not putting their homes on the market, and that impacts affordability,” Garrity explained.

Canina agreed. “What’s causing fewer homes to be available for purchase is that so many of them are tied to a sub-3% mortgage,” he said, a situation that took many years to develop.

Essentially, when interest rates cratered after the Great Recession (and fell again in the immediate wake of the pandemic), many homeowners refinanced to take advantage. And many of them who might otherwise looking for a new home don’t want to trade in that rate for something around 7%, so they’ve been sitting on their homes, reducing inventory in the market.

“I don’t know how long it’ll take before that changes, because so much of the banks’ books are now 3% on 30-year mortgages,” he explained, and the refi market has been non-existent.

“Once you get below 6% mortgages, you could start seeing an increase in residential lending refinancing, as people with 7% mortgages might want to refinance to, say, 5.5%,” he added — but that won’t be immediate. “Typically, you have a delay. No one wants to jump in immediately, and we don’t know what the inflection point will be to spur increased demand.”

“It’s been steady. I think, because of general uncertainty, you’ve got people sitting on the sidelines. I wouldn’t say it’s robust market, but it’s not a stalling market. There is activity going on; it’s just modest.”

Still Canina stressed that, “for new mortgages, the demand is not being driven by an interest rate; it’s being driven by the availability of homes in the market” — which causes prices to soar, creating another barrier for people to get into homeownership.

Broad View

Overall, banks are generally optimistic about the current environment, after struggling with profitability following those sharp rate increases in 2022 and 2023 and building back from that ever since.

“As we move through this environment, it’s been a very good year for us,” Garrity said. “We continue to grow customers, and we’re growing and expanding our footprint, opening a new branch in Holyoke early next year. It’s been a successful 2025 for us, and it’s looking to be a successful 2026 as well.”

On the lending side, Canina noted, “it’s been steady. I think, because of general uncertainty, you’ve got people sitting on the sidelines. I wouldn’t say it’s robust market, but it’s not a stalling market. There is activity going on; it’s just modest.”

He believes lending activity will respond to clearing skies, however, and lowering rates won’t hurt.

“The uncertainty is due to what’s happened and what’s going to continue to happen in the economy. People don’t want to make a commitment because they’re unsure where the Fed’s going to go, where the economic indicators are going, where the administration is going with tariffs. When that finally gets played out and there’s more stability, we’ll see what will happen. We could end up with lower rates in lending, but not an increase in economic growth because a lot of that could be potentially from refinancing.

“Anytime you have a very low interest rate environment — for example, coming out of the Great Recession or coming out of the pandemic, when interest rates were at all-time lows — you then have a period of significant increases in refinancing loans, and mortgage financing goes way off,” Canina elaborated. “Even on the commercial side, we will always have a lot of borrowers coming back to the table looking to see if they can refinance. If rates go up, it’s going to have an opposite effect.”

For now, interest rates seem to be on the decline — not to those post-pandemic levels, but lower than the past few years — which comes as good news for borrowers, and an optimistic yet still complicated picture for banks.