How Do Banks Determine Mortgage Interest Rates?

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Have you ever wondered why banks continually change mortgage interest rates? There are many factors that help lenders determine both fixed rate and ARM mortgages. This video will explain how the interest rate is determined.

There are many factors that affect mortgage rates including government bonds, rates that the government sponsored enterprise charge and the London Interbank Offered Rate. In this information program, we will discuss how these benchmarks are used to help bankers determine mortgage rates.

One common benchmark cited for determining mortgage rates is the Federal Funds rate. This is the rate that banks charge other banks for overnight operations. That rate is currently in a range between zero and 0.25 percent.




The discount rate is the Federal Reserve's primary interest rate. This is the rate that the Federal Reserve, also known as our central bank, charges member banks. Unlike the Federal Funds rate, the Federal Reserve Bank has absolute power in determining this interest rate. The current primary rate for the member banks is 0.75 percent. Banks that are not eligible for this primary rate are charged 1.25 percent. A third seasonal rate is for small depository institutions that need to meet seasonal requirements.

The Prime Rate is what banks charge their best customers, usually corporations and large companies. This rate is typically 2.5 to 3 percent above the Federal Funds rate.

These rates rarely change, so why do mortgage rates fluctuate so frequently? There are other benchmarks, including government bonds. The "Capital Markets" play a major role in mortgage loan rates.

Investors are constantly looking for safety and a return on their investment. The safest investment has U.S. government bonds, notes and bills. But the rate of return is relatively meager compared to what they could get buying other securities.

Investors willing to take a little more risk might consider stocks or mortgage backed securities. Typically, in better economic times they are willing to make riskier investments.

Government securities have historically been considered low risk investments. Similar to a heard of cattle or sheep, after the sign of economic uncertainty investors will flock to these securities. This drives down yields.

Here is an example. Let's say there is a 100 dollar Treasury bill offered that will pay 110 dollars on maturity. If there is a lot of demand for the T-bill, the price will increase. You might bid 100 dollar, but your neighbor may bid 105 dollar for that same security. The higher the price for that T-bill will lower the yield. Rather than yielding 10 dollars at face value, the bill will not yield only five dollars.

Conversely, when demand for bonds fall, the interest yielded on them increases.

Banks and other lenders are also in competition for investor dollars. If Treasury yields go higher, banks need to offer investors a better return on their investment too. Thus, they need to increase the interest rate to the homeowner / borrower.

Since the 30-year mortgage is usually paid-off or refinanced before 10 year, the 10-year note is one of the better benchmarks bankers use to determine mortgage rates.

Since buying mortgages is more risky than buying government Treasuries, banks need to pay a premium for that risk. That premium has historically been around 1.5 to 2.0 percent. If the 10-year note is providing a yield of three percent, expect the 30-year mortgage interest rate to be somewhere around 4.75 percent.

The Adjustable Rate Mortgage (ARM) will usually carry a 30-year term but will have a variable interest rate starting after 5 years. Typically the rate will adjust once a year after that.

Banks will use several benchmark indexes to make that adjustment. The most common benchmarks are the London InterBank Offered Rate, or LIBOR, and the Prime Rate.

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