If the fed interest rate is 3.75-4%, why is the average mortgage rate above 7% and most savings accounts are below 3%?
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Bank need to make money somehow, and typically one source of revenue is by charging more for loans than they pay to borrow funds.
Oh god, sorry if this gets over-complicated but it’s a rabbit-warren of strange terms not in use by your average person.
Your mortgage lender lends you 100k at 1% for 10 years. To hedge their risk of rate changes meaning they might not make as much money (in their eyes, lose money), they go out to wholesale and do a swap with someone where they agree a notional amount (100k in this case) over a term (10 years) where they pay 0.5% and receive a variable rate.
So mortgage fixed rates are based on what the lender can get in the wholesale market on a swap or swaps used to hedge their lending.
Swap pricing is only tangentially related to central bank rates tbh. There’s a whole other load of gubbins parties use to build their swap curves. But they *generally* follow the same trends.
Also, I’ve only experience of UK based wholesale stuff, your extra-uk stuff mileage may vary. A 10 year fixed rate on a mortgage in the UK is very rare, people and lenders mostly do 2-5 year fixed rates.
Edit/balls forgot to add, savings fixed rate accounts follow the same method but obviously the hedging is inverted, meaning you swap to pay a variable rate and receive a fixed rate.
So the wholesale market is based on where people think swap curves are going to look like X years down the line, and therefore what they’ll offer/accept on the fixed leg.
Example, in the UK under the last prime minister, she and her chancellor decided to do some things, and the wholesale swap market went bonkers: no-one had any idea about how to price swaps. So a lot of UK lenders immediately pulled all their fixed rate mortgages from the market, because they just couldn’t hedge them.
There’s also net interest margin to spraff on about, which is the difference between interest received Vs what you’re paying…. It all gets incredibly complex very quickly.
The fed rate only applies to rate that banks pay to the Fed for overnight borrowing to maintain reserve requirements. But other interest rates are typically pegged to the Fed rate and move in close lockstep to it. So when Fed rate was 0, then mortgages were about 3%. When Fed raises rate to 4%, mortgages remain about 3% higher at 7%. Interest paid by banks is similarly somewhat pegged to Fed rate but will be lower as banks’ revenue comes from the spread between interest charged to borrow and interest paid on deposits.
Put yourself in the position of the bank. (ELI5)
1) Say you own a bank have 100million dollars to lend out. With just a few keystrokes you can deposit that 100m in the Central Bank and earn 4%. The Central Bank has zero risk of default. Or you can find 200 customers willing to borrow 500K each for their mortgages, go through all the paperwork to verify their creditworthiness, lend out the money and hope they all pay back their loans over a long period. Why would you spend all that extra money and time and additional risk and earn 4% – surely you’d demand more to lend out to small borrowers?
2) Say you own a bank and want to borrow 100m dollars. Again, (assuming you’re a creditworthy bank), with a few keystrokes, it is possible to borrow that money from the Central Bank and pay them 4% (or so). Or you set up many branches, hire lots of people and open retail savings account and working hard to get deposits to reach 100m dollars. Well you’re not going to pay these savings accounts 4% because because you have to justify all that additional cost of borrowing the money – you’ll pay them less than 4%.
Because banks exist to generate profit, so when they loan you money, you pay a lot of interest, and when you loan them money (your deposits) they pay a little interest.
Mortgage rates are tied to the Fed rate plus about 3-ish. So if the rates are zero, a mortgage is around 3%. When rates are 4, mortgage are around 7%. Why is it 3 points? That’s where competition in the market has settled around at. If a bank charged 4-5 points over Fed rate, they would lose business to competitors, and if they charged 1-2 points over it wouldn’t be enough profit to justify the risk. So the market settled around that 3-ish number
As for interest rates, thing of the Fed rate as how much the banks have to pay to borrow money. If they can borrow from the federal reserve and pay 4%, why would they pay you more to borrow money from you? They will pay you less because you are not as solid a lender as the Fed.
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