How Mortgage Interest Rates Are Set

What Determines Consumer Interest Rates?

Article by Mark Young

There are essentially three mechanisms that control interest rates that affect all U.S. consumers. First, the Federal Reserve Board of Governors meets periodically in closed, private session to monitor current monetary policy and national economic conditions. At these meetings the Board also can change the Federal Funds Rate which is the rate at which member banks of the Federal Reserve System can borrow money from the "Fed". These overnight loans help banks meet on-going federal liquidity requirements and capital ratios. They also enable the banks to lend more money, a credit easing for consumers.

This is also referred to as monetary expansion. When the Federal Funds Rate is changed, large commercial banks almost always respond with a corresponding increase or decrease in the U.S. Prime Rate. The Prime Rate determines, with additional profit margin added by the lender, what banks, finance companies and private investors charge for secured (collateral-backed) and unsecured personal and business loans, credit cards, student loans and installment loans for automobiles and trucks. As of April 17, 2008, the U.S. Prime Rate is 5.25%.

In addition, adjustable second mortgage rates are also determined by the U.S. Prime Rate. HELOC (Home Equity Line of Credit) rates are set by lenders based on the loan amount, loan-to-value, income, mortgage loan payment history, debt structure and middle credit score (FICO) of the borrower. Fixed second mortgage rates are based on the securities market discussed next.

Second, residential home mortgage fixed rates are determined by the mortgage-backed securities (MBS) market traded on Wall Street by large commercial banks, investment banks, wealthy individual investors, foreign governments (China, England, Germany, Japan, Saudi Arabia, United Arab Emirates, Dubai, etc.) and financial institutions like insurance companies and stock equity firms. Residential mortgages are sorted by loan amount and underwriting risk factors, bundled together into tens of millions of dollars, securitized, then traded, bought and sold on the MBS market. The benchmark rate for the fixed-rate mortgage is the 10-year U.S. Treasury Bond which is traded in denominations of $10,000 on the market. Typical, 30-year-fixed rates for prime borrowers average about 1.50% higher than the Treasury Bond rate. 10-year, 15-year and 20-year fixed mortgage rates are based on the 30-year rate and are slightly lower.

Third, adjustable-rate mortgages (ARMs) carry terms ranging from 1 to 10 years. These rates are set by the lender with a profit margin added to an index which changes periodically. These indices include the 12-month Monthly Treasury Average (MTA), LIBOR (London Interbank Offer Rate), Constant Monthly Treasury Average (CMTA) and U.S. Prime Rate, among others. Some indices are more stable over time than others. Informed and assertive consumers can decide for themselves when selecting an ARM loan product and its index.

Since August 2007, we have experienced very volatile financial and commodities markets. It is not unusual for fixed mortgage interest rates to change .125 to .250% from day-to-day or week-to-week. In the history of these markets, these are huge changes! Currently, some wholesale lenders quote interest rates 4 times per day to their approved brokers! The borrower's risk can be reduced by formally locking in the mortgage interest rate for 30 or 45 days, depending on the lender's policy.