How Do Banks Set Rates?
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How lenders get money
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Banks and other lenders make profit off of what is called rate spread. They "buy" money at a low rate and then lend it out at a slightly higher rate, keeping the difference as profit.
Lenders can buy money in a variety of ways. The first way is by paying depositors. Your local bank pays you 2 percent on a 10-year CD, for example, and uses the funds to issue a 15-year mortgage at 5.25 percent. The other way banks get funding is from central banks that offer loans to banks at very low rates. This super low rate is called the fed funds overnight rate.
Components of rate markup
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Once lenders "buy" their money they need to mark it up for retailing. The markup accounts for all risks and internal costs as well as bank profit. Not all loans will be repaid so banks assume a percentage of loans will be written off. Internal costs to lending include all bank overhead such as salaries and marketing costs. Bank profit is the amount of markup between the lenders' cost of funds and market rates. This profit is returned to the banks' ownership and creditors.
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Supply and Demand
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Every bank takes the same factors into consideration when setting rates, but ultimately supply and demand determine rates. Supply and demand come into play when obtaining funds from depositors or lenders and when issuing loans to the public. The greater the supply of loans, the lower rates will be.
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