How is my interest rate calculated?

Here’s how a bank breaks down an interest rate.

Cost of Funds is exactly what it implies- it is the bank’s cost to provide you with X loan.

Credit Risk Spread: This is the implied risk the bank takes on in the scenario a borrower defaults.

It’s broken into two parts: idiosyncratic and market-wide risk.

Market-wide risk is the required return of the bank to compensate for general market conditions. This is to say, the more competitive/in-demand the market is, the smaller this portion of the spread likely is for a borrower.

Idiosyncratic risk is specific to the individual borrower. If the bank is looking at a mortgage for an individual, for example, things such as credit score and existing debt, in addition to how many signers (guarantors) play a factor in the spread.

Market Risk Spread is the non-credit based portion of the spread. It is added to compensate for potential changes in the overall value of the loan due to changes in the market/overall economy.

It is broken down into 3 segments: Liquidity Risk, Duration Risk, and Prepayment Risk.

Duration Risk Spread is added depending on the length of the loan. A longer loan implies more sensitivity to the market & therefore, a higher interest rate

Liquidity Spread: This is the implied ability to be able to liquidate the collateral in the loan.

A bank will have a harder time selling a restaurant’s furniture, for example, than they would the restaurant’s building. Therefore, the building would have a lower spread here.

Prepayment Risk: This is the potential for loss of future cash flows.

Borrowers that ask for no prepayment penalties can, in many cases, get one. However the effects on a bank’s balance sheet from potential loss of the cash flow can cause this premium to increase.