How do banks set interest rates?

How banks set rates

Understanding how banks set interest rates can help you make better informed decisions, particularly in regard to identifying the best lender to use. There are three main factors that influence rates. And some products and lenders may be influenced by only one or two of these factors.

1) Cost of funds

‘Cost of funds’ refers to the cost to the bank to source the money it lends to borrowers. The banks typically fund their mortgages through three sources (listed in order of most costly to least costly):

1. Deposits – the bank receives deposits from individuals, super funds and corporates (i.e. term deposits, high yielding at-call accounts, etc.). The cost of this line of funding is determined by the level of competition for deposits.
2. Long term debt securities – the bank sells long term bonds to institutional investors and pays a coupon (interest rate) on those bonds. The cost of this funding is determined by the market i.e. it is influenced by the laws of supply and demand.
3. Short term securities – this is similar to # 2 above but the bond terms are typically less than 6 months.

To add to this, banks must maintain capital adequacy ratios which means that they need to hold a certain amount of equity compared to the amount of mortgages they have made. Equity is very expensive (as shareholders expect high returns). This adds to the banks ‘cost of funds”.

One way to reduce cost of funds is through securitisation. Securitisation involves bundling up hundreds of mortgages and selling them to investors as ‘mortgage bonds’. This takes the mortgages off the banks’ balance sheet meaning that they don’t have to fund them using the above 3 sources.

Impact on cost of funds

Over the past decade, the government has required the banks to change the way they fund mortgages which has increased its cost of funds. They have done this to reduce the banks’ risk and make them stronger – to avoid another GFC. They government wants more mortgages funded by deposits, more long-term debt (and therefore less short-term debt) and require them to hold more equity. The government has also limited the use of securitisation.

Different for non-banks

Some non-banks (non-deposit taking institutions) fund all their mortgages via securitisation and sometimes this can put them at an advantage as their ‘cost of funds’ can be lower than the big banks.

2) Competitive pressures

Like in any business, banks sometimes have to compete on price (i.e. interest rates). Some products and markets have more competition than others – although it doesn’t always seem that way as the banks tend to move in unison (the recent abolition of ATM fees is a good example of this).

Banks tend to like to use fixed rates to win new business because they know that they will retain the customer for at least as long as the fixed term. This makes the profitability of these loans more certain and therefore they can be more aggressive with pricing/margins.

Some sectors lack a lot of competition – SMSF loans being one very good example. None of the banks will offer discounts off the standard variable rates for SMSF loans.

3) Government pressures/regulation

As I have written about previously, the government (APRA) has demanded the banks reduce the amount of investment and interest only lending over the past 12 to 18 months. They have also put pressure on the banks to tighten credit policies.

The upshot of this means that some banks just don’t want certain business. The interest rate ‘discount’ you will receive will be determined by three things:
1. whether you are borrowing for investment or owner-occupier purposes;
2. whether you want interest-only or principal-and-interest repayments; and/or
3. the percentage of the property’s value you want to borrow (i.e. loan-to-value ratio or LVR).

For example, if you need an investment loan with interest only repayments and you want to borrow over 80% of the property’s value, then you should not expect a big discount – the banks just don’t want this business (so you are probably better off using a non-bank lender). However, a home loan on principal and interest repayments under a 70% LVR is highly desirable.

Choosing a lender

How a lender funds its mortgages, the different levels of competition and what levers the government is pulling are all important considerations that will help determine which lender might be the most suitable for your situation.

Choosing the right lender will not only have a material impact on price (interest rate), but will also have a large impact on how ‘easy’ (dare I use that word when referring to working with the banks) it will be to gain the loan approval and set everything up.

If you need assistance with identifying the best lender for your circumstances, do not hesitate to reach out to us.