What drives consumer interest rates?

Interest rates are essentially the price of a loan. But how that price is set and why it changes can mystify consumers.

Most consumers are already familiar with some factors affecting rates, such as credit scores and down payments. These factors are staples of consumer finance news because they help consumers understand how to get the lowest rate.

Other factors, such as the market for asset-backed securities and monetary policy conducted by the Federal Reserve, receive less attention, perhaps because they’re beyond consumers’ control. But they can help explain why rates today are different than before.

Basic models for rate setting

Lenders typically use a “cost-plus” model to set interest rates. This means there’s a base rate determined from the cost to fund the loan, with a margin added on top.

How lenders calculate the cost varies, but it’s generally driven by a few factors:

• Interest rates that banks and other depository institutions must offer for customer deposits. These deposits are used by many banks to fund loans.
• Interest rates on loans from other banks. Lenders, especially nondepository institutions like independent mortgage companies, often borrow money to fund loans.
• Benchmark rates set by the government or industry. These can vary depending on the kind of loan. Rates for short-term loans, such as credit cards, or loans with variable rates may be benchmarked against the prime rate, the rate banks offer to their most creditworthy commercial customers. This rate is in turn benchmarked against the federal funds rate, which is the rate banks charge each other for overnight loans. Rates for long-term loans, such as mortgages, may be benchmarked against the 10-year Treasury note.

The margin has many layers serving different purposes:

• Paying for overhead costs, such as the cost of servicing the loan.
• Compensating lending institutions for the risk that a borrower might default; credit scores and down payments affect this.
• Profits for lenders. How large a profit depends on how competitive the market is and what institutions feel they need to ensure they’re making the best use of their funds.
• Profits for investors, which is based on what’s happening in the asset-backed securities market, where loans are bought and sold.

Here’s how the base and margin work for some common consumer loans.

Mortgages

Home loans are among the most common kinds of consumer loans, but they’re different from other kinds of loans.

Traditionally, banks are seen as intermediaries between borrowers and savers. But the dominant players in home loans are independent mortgage companies that are more like intermediaries between borrowers and investors. These nondepository institutions fund mortgages with loans from banks or other sources and then sell the mortgages to investors as mortgage-backed securities, a type of asset-backed security.

Many banks also sell home loans; though, as a group, they do so less often than mortgage companies (Figure 1).

The base rate for mortgages is usually benchmarked to the yield on 10-year Treasury notes. Government bonds are considered the safest investments and thus useful benchmarks for investors.

The yield on Treasuries, which is determined through a public auction, also represents investor expectations of future economic conditions.

Note that even though 30-year fixed-rate mortgages are among the most common home loans, they’re still benchmarked to 10-year Treasuries because most homes are sold or refinanced within 10 years.

The margin is commonly divided between lenders’ overhead and profits and investors’ risks and profits. One investor risk is a homeowner refinancing earlier than expected, usually when interest rates are low. Refinancing can affect investor returns because they had expected to continue receiving higher income from mortgage-backed securities issued when interest was high.

Margins can vary quite a bit (Figure 2), especially during times of economic uncertainty, reflecting additional risks for investors.

Auto loans

Auto loans are similar to mortgages in that many aren’t issued by banks or other depository institutions, and they’re often sold to investors.

Nondepository institutions account for about half of auto loans. Among them are the financing arms of automakers, which mostly focus on new car sales; independent auto finance companies, which mostly focus on used car sales; and dealers themselves. Finance companies work along the same lines as mortgage companies.

Auto lenders differ in how they think about base rates, but a common benchmark is the yield on five-year Treasuries. That maturity period aligns with the terms of new auto loans, which now average 65 months.

But economists have found that margins can vary significantly. Many auto lenders are dealers or automakers who may be more driven to sell cars than to maximize earnings from financing activities. Automakers, for example, may lower margins to entice buyers. Some even offer no interest for an introductory period. Dealers may cut car prices and make up for it by increasing margins on loans they arrange.

Another reason for the wide differences in margins may be the wide differences in the creditworthiness of borrowers. Where mortgage lenders usually require borrowers to have relatively high credit scores, auto lenders also serve people with more limited means.

Why do lenders sell loans?

The rise of mortgage-backed securities in the 1980s and, following that, asset-backed securities for other types of loans has made it possible for lenders to offer more loans to consumers.

For lenders, selling loans offers some obvious advantages. First, they can transfer risks to investors.

They can also offer more loans—and collect more fees—for a given amount of customer deposits. Banks are subject to liquidity requirements, meaning they must reserve a certain level of cash or assets that are easily converted to cash. If they don’t sell loans, lending would slow as they wait for old loans to be repaid before issuing new loans.

Independent mortgage and auto finance companies, whose business models are based on high loan volumes, rely on the asset-backed securities market.

Many depository institutions continue to hold on to some mortgages and auto loans, and earn revenue from the interest on those loans. This is more common among credit unions and smaller banks. In some cases, lender institutions may issue loans that make sense for them and their customers, but don’t conform to guidelines needed for packaging in an asset-backed security. Some lender institutions are simply less connected to these markets.

Depository institutions are also among the biggest buyers of mortgage-backed securities, particularly those guaranteed by Fannie Mae and other government-sponsored enterprises. These securities allow institutions to still earn revenue from interest payments. But liquidity requirements are more favorable toward guaranteed mortgage-backed securities, which can be converted to cash much easier than loans.

The role of the Federal Reserve

The Federal Reserve is often said to have a significant influence over consumer interest rates. But the extent of that influence depends on the kind of loan. The Fed significantly influences overnight lending rates that affect credit cards and adjustable-rate mortgages.

But the Fed’s influence on interest rates for longer-term loans, such as mortgages, is more indirect.

The Fed, through “forward guidance”—announcements about monetary policies it expects to undertake—can shape investor sentiment. These sentiments then affect auctions of the benchmark 10-year Treasuries. For example, the Fed didn’t begin lowering short-term rates until September 2024, but 10-year Treasury yields and mortgage rates were already falling in August when the Fed telegraphed impending rate cuts.

In recent years, the Fed has had a more direct effect on mortgage rates through “quantitative easing.” To support the housing market during the Great Recession and the pandemic, the Fed became the biggest mortgage-backed securities investor in the world: As of February 2025, it owns $2.2 trillion in mortgage-backed securities (Figure 3). By increasing demand significantly for mortgages, the Fed lowered the rates needed to make those mortgages attractive to buyers during the economic crisis.