Key Takeaways
- Banks earn a profit through the net interest margin, the spread between loan and deposit rates.
- The Federal Reserve influences interest rates with policies like the federal funds rate.
- Banks consider market conditions, competition, and federal policies when setting interest rates.
- A borrower’s credit score, collateral, and down payment impact the offered interest rate.
- Economic factors such as GDP, inflation, and local market competition affect loan rates.
Banks set interest rates to maximize their profits while balancing federal policies, trends, and competition. They consider guidance from the Federal Reserve, broader economic indicators, and the creditworthiness of individual borrowers when they make these decisions. Factors like inflation expectations, local conditions, and loan demand also help banks determine the rates they offer.
How Banks Formulate Interest Rates
Banks are generally free to determine the interest rates they will pay for deposits and charge for loans, but they must take into account competition, market interest rates, and Federal Reserve (Fed) policies.
The Fed influences interest rates by setting certain rates, stipulating bank reserve requirements, and buying and selling “risk-free” U.S. Treasury and federal agency securities, which affect the deposits that banks hold at the Fed.
This is referred to as monetary policy and is intended to influence economic activity, as well as the health and safety of the overall banking system. Most market-based countries employ a similar type of monetary policy in their economies.
Fast Fact
The fed funds rate is the rate at which banks lend to one another while the discount rate is the rate the Fed lends to member banks.
The primary vehicle the U.S. Fed uses to influence monetary policy is setting the federal funds rate, which is simply the rate that banks use to lend to one another and trade with the Fed. When the Fed institutes interest rate hikes, profits for the banking sector rise.
Many other interest rates, including the prime rate, which is a rate that banks use for the ideal customer with a solid credit rating and payment history—usually corporate ones—are based on Fed rates such as the fed funds.
Other considerations that banks may take into account are expectations for inflation, money demand and velocity, and stock markets, among others.
Key Market Influences on Interest Rates
Banks look to maximize their NIM by determining the steepness in yield curves. The yield curve graphically depicts the difference between short-term and long-term interest rates. Generally, a bank looks to pay short-term rates to depositors, and lend at the longer-term rates. If a bank can do this successfully, it will make money.
An inverted yield curve, which means that interest rates on the left, or short-term, spectrum are higher than long-term rates, makes it quite difficult for a bank to lend profitably. Fortunately, inverted yield curves occur infrequently and generally don’t last very long.
Important
While the Fed controls monetary policy in the U.S., Congress controls fiscal policy, which includes tax policy and government spending.
Banks base the rates they charge on economic factors, including the level and growth in gross domestic product (GDP) and inflation. It also cites interest rate volatility—the ups and downs in market rates—as an important factor banks look at.
These factors all affect the demand for loans, which can help push rates higher or lower. When demand is low, such as during an economic recession, like the Great Recession, banks can increase deposit interest rates to encourage customers to lend, or lower loan rates to incentivize customers to borrow.
Local market considerations are also important. Smaller markets may have higher rates due to less competition, as well as the fact that loan markets are less liquid and have lower overall loan volume.
Factors in Setting Individual Loan Rates
As mentioned above, a bank’s prime rate—the rate banks charge to their most credit-worthy customers—is the best rate they offer and assumes a very high likelihood of the loan being paid back in full and on time. But as any consumer who has tried to take out a loan knows, a number of other factors may come into play.
For instance, how much a customer borrows, what their credit score is, and their overall relationship with the bank all come into play.
The amount of money used as a down payment on a loan such as a mortgage—be it none, 5%, 10%, or 20%—is also important. Studies have demonstrated that when a customer puts down a large initial down payment, they have sufficient “skin in the game” to not walk away from a loan during tough times.
Collateral, or putting one’s other assets—such as a car, home, or other real estate property—down as backing for a loan, also matters.
Loan duration, or how long it has until maturity, is important, as well. With a longer duration comes a higher risk that the loan will not be repaid. This is generally why long-term rates are higher than short-term ones. Banks also look at the overall capacity for customers to take on debt.
For instance, the debt service ratio attempts to create one convenient formula that a bank uses to set the interest rate it will charge for a loan, or that it is able to pay on a deposit.
Overview of Various Loan Interest Rates
There are many other types of interest rates and loan products. When it comes to setting rates, certain loans, such as residential home mortgage loans, may not be based on the prime rate but rather on the U.S. Treasury Bill rate (a short-term government rate) and longer-term U.S. Treasury bonds.
As rates on these benchmarks rise, so do the rates that banks charge. Other loans and rates include government-backed loans such as mortgage-backed securities, student loans, and small business loan rates, the last of which is partially backed by the government.
When the government backs a loan, rates tend to be lower and are used as the basis for other loans made to consumers and businesses.
What Is a Good Credit Score?
Your credit score impacts many areas of your financial life, from the interest rate you receive on loans and mortgages to the success you’ll have in renting an apartment. Credit scores typically range from 300 to 850, and the higher, the better. Depending on the credit score model being used, the exact numbers that determine what is good may vary. However, a good credit score is one that ranges between 670 to 739. A very good credit score is one from 740 to 799. Anything above that is considered excellent.
Can a Bank Change the Interest Rate on a Loan?
If the loan is a fixed-interest rate loan, then a bank cannot change the interest rate on the loan for the duration of the loan. If the loan comes with an adjustable rate, then yes, a bank can change the interest rate of the loan. The changes in the rate may be predetermined or may track an index. Additionally, a maximum increase can be set in the terms of the loan.
How Do Banks Determine the Interest Rate on Your Loan?
Banks set interest rates to correspond to the rates set by the Federal Reserve. They also consider the interest rates charged by competitors. On a specific loan, banks take into consideration the borrower’s creditworthiness, which includes their credit score, income, savings, and other financial metrics.
The Bottom Line
Banks set interest rates using a range of factors, primarily aiming to maximize profits through NIM while accounting for economic conditions and risk. Borrowers can secure favorable rates by focusing on factors like maintaining a strong credit score, offering collateral or a larger down payment, and consolidating their financial services with one bank. Loan timing can also matter, as rates may be more competitive during economic slowdowns or periods of heightened uncertainty. Loans backed by government programs can also often offer lower rates due to reduced lender risk.