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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. They are:

  • 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 government 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. You can look at the official US Treasury website to see the actual, real time fluctuations in the bond market and the 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 turn rates.

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
  • Jobless Rate
  • Weekly Initial Jobless Claims
  • Fed Chairman Speech Before Congress

The key economic indicators that can affect the bond market with corresponding fluctuations are:

  • Consumer Confidence
  • Retail Sales
  • Manufacturing Activity
  • Industrial Production
  • Jobs Growth
  • Inflation

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