How Are Interest Rates Set
How are interest rates set -- a common question received by
those who broker loans. The first thing most clients or prospective
clients will ask is "how are rates doing?" Or, "what rate can I get?"
It's understandable as the interest rate determines in large part as to
what your monthly payment will be. Fundamentally, the interest rate is
what you pay the lender in exchange for their lending you the money for
your home loan.
How Are Rates Set?
So, how are rates set? Generally speaking, the longer the loan
the more the risk to the lender and consequently the higher the rate.
Of course, it's not as simple as that for there are a number of factors
that determine how rates are set. Here's the nitty-gritty as to how
your California home loan interest rate is set. There are three
fundamental forces that determine interest rates in the United States.
The Federal Reserve
The Bond Market
Multiple Forces in The Economy
The Federal Reserve
The "Fed" as it is commonly called determines US monetary policy
for the entire country. There was no central federal banking system in
the US from 1783 to 1913 but that all changed with the Federal Reserve
Act of 1913. Ostensibly, it is the central bank of the US. Don't let
the term "Federal Reserve" throw you -- it is NOT a federal US
government institution or department.
It is a privately-held organization. There are 12 regional
Federal Reserve System banks throughout the US. In addition, the
Federal Reserve seeks to constantly adapt its various monetary policies
in a concerted effort to combat inflationary and deflationary pressures
brought about due to changes in the domestic or global economy. The
Federal Reserve Board members meet eight times a year and generally
only changes rates during a meeting. The 12-member Federal Reserve
Board can control interest rates by changing the rates it charges banks
to borrow money.
Here's how it can influence rates. The Federal Reserve loans
banks funds from their district Federal Reserve bank who pledge their
commercial paper as collateral. The Fed essentially charges the
borrowing bank interest on the loan. This is called the discount rate.
Banks or lenders then lend the consumer or borrower money charging
their primary interest rate. The implications are self-evident. The
higher the discount rate the Fed charges the bank, the higher the
primary interest rate will be to the borrower as the bank wants to meet
the minimum requirements as well as make a profit.
Many people think that when they hear the Federal Reserve
Chairman make a monetary policy change with the Prime rate, it
automatically affects interest rates. Not so. The Prime rate increase
or decrease may affect a Home Equity Line of Credit (HELOC), but it
wouldn't affect interest rates. Interest rates also fluctuate with the
various loan programs available to the borrower. (For more information
on Loan Programs within this site, please click here.)
The Bond Market
The bond market fluctuates on a daily basis and is a major
determinant in the setting of interest rates. In fact, one can actually
guess with an astonishing degree of accuracy as to any movement within
a business day if there will be a rate adjustment, whether up or down,
based on what the bond market is doing, specifically the 10 year bond.
For clarity's sake, there a couple of different bonds that affect
interest rates. They are:
The 2 Year Bond
The 5 Year Bond
The 10 Year Bond
The 30 Year Bond
The primary bonds that affect interest rates are the 10 year and
the 5 year bond. To see actual, real time fluctuations in the bond
market, go here at http://money.cnn.com/markets/bondcenter/ to see
current prices for bonds. This is the one I view daily. The bond market
is highly volatile. How do you read the graphs so as to know if
interest rates will have a spike downward or upward?
While looking at the 10 year price graph (the farthest one on
the right), if the 10 year price has a massive swing upward from say 99
28/32 to 103 28/32, rates most likely will have a decrease from current
levels. On a daily basis, California loan agents receive rate sheets
from lenders (we work with over 400 lenders so they are plentiful).
If the bond market fluctuation merits an increase or decrease
in the loan broker's yield spread premium (their rebate), it will in
turn affect the interest rate that is quoted to a client, which in this
example would be a lower rate. If the bond price doesn't have much of a
fluctuation during a normal business day, the rate will not move. Every
day, in the morning, rates are received in the office. If a price
adjustment is required, the primary lenders will immediately issue an
adjustment rate sheet to their broker partners.
As I've said, interest rates are set based on the yield in
the bond market at any given time. Let's show an example. If, for
example, a $100,000.00 bond falls in value to $95,000.00, the
corresponding yield (return) is significantly higher. Because the yield
is higher, the prevailing interest rate that is set for the mortgage
must offset the higher yield and provide a return on the mortgage for
the lending institution. With all things being equal, the rates on
fixed rate mortgages would tend to rise.
Multiple Forces in The Economy
There are many factors influencing interest rates for your
California home loan in the US economy. Higher interest rates can cause
fluctuations in the stock market which in turn affects the bond market.
In fact, the bond market and the stock market are opposite sides of the
same coin. One can't move without the other. If the US Dollar rallies,
bonds dip; when oil prices dip, bonds can as well. Generally speaking,
when the bond market is up, the stock market is down. In addition, if
economic news is worse or better than expected, it will cause a
fluctuation in the US dollar currency pairs in the spot Foreign
Exchange market (the FOREX), which can affect the bond market and in
A quick example. A couple of weeks ago from this writing, the
US New Jobs report was projected at 350,000 -- it only came in at 10%
of that or 35,000. Once the report was announced, literally IMMEDIATELY
the GBP/USD currency pair (Great British Pound and US Dollar) spiked
upward. The GBP dramatically increased in strength with the US Dollar
becoming weaker. One FOREX trader I know literally made $3,500 in five
minutes as he projected the claims to be much less than expected.
Also, interest rates dropped that day due to the lackluster
jobs report. Coming into the office that day, a wise loan agent would
have locked some loans or at the least knew interest rates would had
gone down that day. Truly, the US economy is a highly interdependent
organism that is very fluid and dynamic -- it is never static or
motionless. Some of the key economic indicators that affect the
economy, and in turn interest rates, are:
Durable Goods Orders
New Home Sales
US Trade Balance
Weekly Initial Jobless Claims
Fed Chairman Greenspan Speech Before Congress
The key economic indicators that can affect the bond market with corresponding fluctuations are:
There you have it. There are many forces at work in determining
what your rate is on any given day. So the next time you ask a loan
agent, "what are rates like today?" You'll see there's a lot behind it.
by Glenn Reschke