How Are Home Equity Loan Rates, Mortgage Rates Determined?

You often hear about the Federal Reserve raising or lowering interest rates. But do you really understand how that affects the rates you pay for home equity loans and mortgages — or even credit cards or car loans?

With interest rates, almost everything is relative. With a few exceptions, most rates consumers pay are pegged to other rates, from the Fed’s benchmark target rate for overnight loans from one bank to another to the prime lending rate that banks charge their best customers.

The duration of the loan plays a big role.

According to the San Jose Mercury-News, much of the shorter-term interest you pay is pegged to the most discussed interest rate in the country, the Federal Reserve’s federal funds rate, which is the target interest rate for overnight loans from one bank to another.

The target rate is set during the Fed Open Market Committee’s eight regularly scheduled meetings a year; it is called a “target” because actual rates paid are set by the market. The Fed Funds target rate is currently 5.25 percent, but in late October, the “effective” daily Fed Funds rate fluctuated from 5.23 to 5.26 percent.

The Fed Funds rate is the benchmark banks use to set their “prime lending rate,” the rate they charge their best customers. Usually 3 percent above the Fed Funds rate, the prime rate is important because it is used to set home equity loan rates and credit card rates.

The rate consumers pay is always higher than the prime rate, a difference called “the spread.” The spread occurs because lenders will only loan money to riskier customers if they’re paid extra for that risk — thus the high-interest, higher-risk bad credit mortgage.

The spread is determined in part by the consumer’s credit worthiness and whether the consumer’s loan is secured. Since a bank can repossess your house if you don’t pay your home equity loan, you’ll pay lower rates on such a loan than you would on an unsecured credit card loan — this is especially true if you have bad credit.

“When a loan is unsecured, they can threaten you, they can call you, they can send lawyers after you, but if you don’t have any money to give them, you don’t have any money to give them,” said Keith T. Gumbinger, vice president of HSH Associates, a publishing company that tracks mortgages and other loans.

That said, if you have a much better credit score than your brother, you should also be able to get a loan or credit card with much lower interest payments. Likewise, the U.S. government is more credit worthy than U.S. consumers; and while mortgage rates have a correlation to the rates on 10-year Treasury bonds, mortgage rates are always higher.

It also comes down to basic economics. Supply and demand also play a large role in determining some interest rates, such as those for mortgages and car loans. When demand for something drops off, rates can fall with it.

One reason why mortgage rates are correlated with 10-year notes is that few mortgages last their entire 30-year term: Studies show that most people are likely to move or file for a home mortgage loan refinance within 10 years.