How banks set your interest rates

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Updated: November 3, 2011 10:13AM

When Standard & Poor’s downgraded the country’s debt rating, most experts thought mortgage rates would start climbing. Yet rates slipped to record lows the following week.

Then consumers were expected to cheer when the Federal Reserve said it would keep interest rates close to zero for another two years. But if the Great Recession is any indication, that’s no guarantee that credit-card rates won’t spike anyway.

Although the linkage isn’t always clear, shifts in the broader economy do ultimately impact how much consumers pay to borrow money. Banks use a variety of benchmarks to set rates on various loans.

Here’s how recent developments could impact four common loans:

MORTGAGES. Rates have been hovering near record lows for the past year, which is why it’s a good time to refinance or consider becoming a homeowner. This era of low rates was expected to start tapering off when S&P downgraded the country’s debt this month. That’s because mortgage rates are tied to the yield on the 10-year Treasury note. The thinking was that a blemished credit rating would require the government to increase the yield on those bonds, raising its total borrowing costs.

But the lack of confidence in the global economy and a volatile stock market caused the opposite to happen. Investors have continued to seek the relative safety of Treasurys, which in turn pushed down yields.

CREDIT CARDS. Most credit cards have variable rates that are tied to the prime rate. So consumers can take some comfort in the central bank’s pledge last week that it will keep the federal funds rate at the current level for the next two years; the prime rate has historically tracked the federal funds rate.

Still, there are a few ways interest rates on existing credit card accounts could spike. Credit card rates are generally set at several percentage points above the prime rate. So banks could simply increase that spread, or the amount they charge on top of the prime rate.

This is exactly what happened during the downturn. The prime rate actually decreased between the start of 2008 and August 2009, but the average spread during that time spiked from 8 percent to 12 percent, according to CardHub.com. Rising delinquency rates prompted banks to raise rates to make up for mounting losses, notes Odysseas Papadimitriou, CEO of CardHub.com. In addition, banks were bracing for a spate of new regulations.

As for newly issued credit cards, interest rates are moving in two directions. Borrowers with a good credit history can now find rates below 10 percent, says Greg McBride, a senior financial analyst with Bankrate.com. Those with spottier credit are seeing higher rates.

STUDENT LOANS. Many families tap federal student loans to finance college educations. These loans come with a fixed interest rate of 6.8 percent in most cases.

Private student loans, in contrast, aren’t as attractive because their variable interest rates tend to be higher. The benchmark most commonly used for private student loans is the London Interbank Offered Rate, or Libor. This is the rate at which large international banks lend each other money on a short-term basis.

Keep in mind that benchmark rates across the board are low right now. So the rate you’re given on a private student loan today could be considerably higher by the time you graduate.

CAR LOANS. Auto financing doesn’t get a lot of attention, even though it’s the second-largest debt for many households. Rates on auto loans generally track 3- and 5-year Treasury notes depending on the duration of the loan, says McBride of Bankrate. This is why rates on car loans, like mortgages, on the whole are pretty attractive right now. The average interest on a 5-year new car loan, for example, is 5.57 percent this month, down from 7.07 percent three years ago.

AP