How is a Mortgage Rate Determined

Committing to a fixed mortgage rate is a stressful process, mainly because of the way in which we can never really be sure that we are securing the best rate moving forward. Nobody wants to take on a fixed interest rate, only to see rates plummet the next day. In order for us to be confident in taking on a mortgage agreement, we need to understand exactly where it is that mortgage rates come from, and what will cause the rates to change.

Mortgage rates are mostly composed of what is called the ‘prime’ rate. The prime rate is the rate at which a bank can borrow funds from its governing body (ie. A central bank), in order to meet its capital requirements. Because of the way in which the bank itself relies on the prime rate as the essential source of the funds that it must lend to borrowers, it will usually list its interest rates as being a function of the prime rate.

From there, a bank will set its interest rate based on its ability to produce a profit from the loan, based on its own reserves. If a bank has a large amount of deposits on hand, it will be less likely to require funds from the central bank, and can therefore provide a more favorable rate for borrowers. Alternatively, if a bank has already loaned out a large amount of its funds, they will be more likely to require additional capital, and will therefore need to charge a higher rate.

The trick to keeping track of the prime rate is to read the news for announcements from the central bank itself. Shifts in the prime rate are generally hinted at well in advance through public announcements from the central bank, and are then publicly announced at pre-approved dates. If an active borrower simply keeps track of when these announcements will be made, they are able to make well informed decisions about how it is that the interest rates will change over the near future.

For example, if there is an announcement from the central bank that states that interest rates will be kept constant for the near term in order to promote market stability, a borrower can be confident in the short-medium term interest rates, at least until the next announcement is made. Alternatively, if an announcement mentions that prime will be decreasing in the near future, the borrower may choose to book an appointment to renew their mortgage early, in order to take advantage of the lower rates.

The second major component of mortgage interest rates is generally determined by the competitive environment. If there are other banks in the near market that are offering particularly favorable rates or conditions, other institutions will generally need to follow in step to keep their existing clients. This can become particularly aggressive in situations where a particular lending is willing to start a ‘rate war’, which is similar to the way in which price wars occur with gas stations.

The way to watch out for these kinds of reductions is by watching the advertisements that lenders are posting. If there is a major institution that is posting a rate that is well below its competition, it is likely that many other lenders will soon also reduce their rates to match. By following up on these competitive trends, a borrower can save as much as a full percentage point on their loan.

While all of this trend following does pay for itself with time, it’s hard for a person to keep track of all these factors just by themselves. That is where professionals such as mortgage brokers come in. In exchange for a commission on the loan itself, a mortgage broker will keep track of lending trends in order to provide the best rate possible for their client. Alternatively, there are plenty of resources available online (such as this very site) that can help you to keep track of how it is that rates are developing.