Inside Mortgages: How Lenders Set Rates

With so many different terms that relate to mortgage rates and how they are set, it might be helpful to compare and contrast some of them in order to get a clearer understanding of the differences.

HELOCs and Other Short-Term Lending

The prime rate is the rate that banks use to lend money to each other.

Many credit instruments, such as home equity loans and lines of credit, automobile loans, and credit card rates, are based on this.

From the perspective of the creditors, this is considered short-term lending, and the rate can change regularly.

Adjustable Rate Mortgages

Rates for adjustable rate mortgages, or ARMs, are based on indices that often reflect the prime rate but are, at the same time, different.

These economic indices include rates of shorter-term Treasury bills, such as the one-year Treasury bill, the LIBOR, which is the London InterBank Offered Rate, and COFI, which is the Cost of Funds Index.

To arrive at a rate that they will offer potential borrowers on a mortgage, lenders take these indices and add what is called a margin to them.

For example, if the rate on an index were to be 3.00% and the lender were to add a margin of 2.5%, the rate the borrower would pay, at least initially, would be 5.5%.

The rate may change over time as the index changes, and as the loan is eligible for rate adjustments, per the terms of the loan.

Fixed-Rate Mortgages

Fixed-rate mortgages, more specifically those that are for 15 or more years in length, are considered long-tem lending.

For the most part, except for very recently, long-term mortgage rates have followed the yield on the ten-year Treasury bill, which tends to change with economic conditions.