| In financial markets, there's a formula that banks use to determine interest rates: Interest Rate = Real Risk Free Rate + Expected Inflation + Default Risk Premium + Liquidity Premium + Maturity Premium Fed bond rates are what determine the 'risk-free' rate. A bank can have the fed hold on to their cash and it is really safe there. Safe enough, that financial markets consider it 'risk free'. This is why all of your loans are dependent on this number. Banks add on a premium for inflation -- they want the dollars they get paid back in to be worth the same in real value, not nominal. They also add a premium for default risk. This is the obvious one -- the riskier the loan, the more the bank will have to charge to break even over a large number of loans, where some of them won't be paid back. The liquidity premium is kind of like a charge for FOMO. If it is hard for the bank to sell (or liquidate) your loan, they might be stuck with a your loan contract in a filing cabinet when they really need some cash. If they can sell your loan on the open market, then they'll give you a better rate here. And finally, the maturity premium is a charge for uncertainty. A bank can be pretty certain that they know what the financial markets will look like in the short term. But for a 30 year loan? The financial market could be a much different beast in 30 years. This is a lot of risk on a bank that has their cash tied up for that long of a period. |