| How do interest rates from banks get determined? Banks are for-profit institutions and, therefore, determine their rates based on what is best for them. Banks function by borrowing money from some sources and lending it to others. Their profit comes from the interest they charge on loans to their customers, which is usually higher than the interest they pay to payback the amounts they have borrowed.
There are several factors that go into calculating interest rates from banks, from the banks point of view. The following will give you some insight into what they look at when someone comes in to ask for a loan:
Risk - Risk is a major factor in determining the rate you will be offered should they decide to give you the loan you request. They determine the risk by what you have to offer as collateral and what your credit score is. To the bank, a high-risk loan requires to have a higher rate going in so that more interest is paid up front so the bank is compensated right from the get-go for the higher chance of default.
Collateral - Risk is partly determined by whether collateral is involved or not. A home loan tends to be considered a lower risk because the house is the collateral and the bank can first, foreclose on the house and then sell the house at auction in the event of a default, thus recovering at least some of its costs. A credit card, on the other hand, is unsecured, which means it does not have any collateral, thus making it more risky for the lender. That is why credit cards have much higher interest rates. Loan Cost - Another interest rate factor is how much the money you want to borrow is costing the bank itself. The higher the bank pays in interest to whomever they have borrowed from, the more it will charge in interest to whomever borrows from them in order to remain profitable and attempt to forego any of the risk mentioned above. Competition - As stated earlier, banks are for-profit institutions and they are continually competing with one another for a share of the market. Therefore, the interest rates they offer to their customers are also influenced by the rates the other banks offer to the customers who come in to their institutions asking for a loan. Prime Rate - The prime rate is the rate that the head of the Federal Reserve deems acceptable and at which major banks can lend their least secured funds to their best customers. It is determined by the competition mentioned above, and influences other loan rates in addition to the other factors, such as term length and risk. Federal Reserve - The Federal Reserve influences the prime rate interest rates from banks by buying or selling U.S. Treasury securities, which in turn influences the rate at which banks loan money to one another, which is usually a very small rate. But banks do not tend to borrow only tens of thousands of dollars they borrow millions at one time. If this rate is higher, interest rates go up as loan costs go up. |