How Do Banks Set Their Interest Rates?

Understanding How Banks Determine Interest Rates

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If you’ve ever tried taking a loan from any financial institution, you must have come across the term “interest rate.” Or, in your interaction with a commercial bank or financial institution, the conversation about interest rates might have come up. So, what exactly is an interest rate?

Interest rate refers to the extra amount charged on top of the principal amount given by a borrower to a lender. Here’s a scenario to help you understand better: 

You approached a bank to obtain a loan of maybe $10,000 (which, in this case, is the principal), the bank approved your request. You’d have to pay back the amount over a determined period (maybe 1 or 2 years). Presumably, by the end of this duration, you paid back $11,000. The extra $1000 you paid back is the interest you had to pay to access the loan. 

According to a report by the Board of Governors of the Federal Reserve System, Consumer Credit increased at a seasonally adjusted annual rate of about 4.7% in July 2021. The revolving credit increased at an annual rate of 6.7%, while non-revolving credit increased by 4.1%. These figures  imply that the number of people looking to access credits/loans from financial institutions is increasing. 

These increasing numbers make it necessary for you to understand how banks determine their interest rates. In this article, we’ll walk you through a comprehensive process to help you get into the minds of these commercial banks. 

With this information, you can better position yourself to access loans from financial institutions when you need them. 

Who Determines Interest Rates? 

It’s one of the first questions that come to mind when the subject of interest rates and commercial banks comes up. Without a doubt, it’s necessary to figure out who determines these rates, considering the interest rate fluidity of commercial banks.

It’d be helpful to know if there’s any central system that regulates interest rates across America.  Or, are commercial banks at liberty to determine their rates however they like? 

In any case, here’s a summary of the key players in the determination of the interest rates of loans in America. 

1. The Federal Reserve System 

The Federal Reserve System is America’s Central Bank. It’s responsible for maintaining a steady financial ecosystem in the country by enacting and enforcing financial directives that keep money in circulation and inflation at bay. To a large extent, the Federal Reserve System plays a crucial role in determining the interest rates commercial banks can charge on loans. 

This organization meets from time to time to review current financial policies and their effects on the American economy. 

Interest rates for short-term loans collected in America are set by the Federal Open Market Committee (FOMC). It’s a 12-person committee consisting of 7 governors of the Federal Reserve System and 5 presidents of the Federal Reserve Bank. 

The decisions of these meetings are enforced by commercial banks, which have to follow directives issued by the FOMC and Federal Reserve System when handing out loans to qualified borrowers. 

2. Retail Banks 

Retail banks focus on offering banking services to individuals, allowing them access to loans and credits and helping them manage their funds via reliable and transparent money management services. 

These financial institutions also play a significant role in determining interest rates. They consider several options before deciding exactly how much interest rate they should collect for lending money to borrowers. 

How financial institutions calculate their interest rates 

As you must have guessed by now, there’s a method to the madness called ‘interest rates.’ Here’s how interest rates are determined: 

1. You should have an idea when you go to open an account. 

Depending on the bank you step into, you should get some memo concerning the bank’s interest rates on all types of bank accounts. 

By paying close attention to the report, you can know how much you’d need to pay when you want to access loans in the future. Information like this is never concealed; if you look for the bank’s interest rates, you can find them expressed in percentage per type of account. 

2. Verdicts from the Federal Reserve System and FOMC are put into consideration 

In the last section, we highlighted the role the Federal Reserve System and FOMC play in the determination of country-wide interest rates. These verdicts serve as an umbrella, and every retail bank/financial institution must ensure their interest rates fall under it. 

The verdicts are known as the monetary policy, which seeks to maintain a fair economic ecosystem where every eligible adult is allowed to access funds when they need them. 

3. The lender has a part to play as well. 

Most people don’t know that their activities affect the amount of money they pay in interest. Regardless of how the Federal Reserve System and FOMC seek to protect the interest of individuals and maintain a steady economic ecosystem, individual contributions affect interest rates. 

Before any financial institution grants you access to credit (allows you to borrow money), one of the first things they ask for is your comprehensive financial statement. Here are some of the things they look out for as they scan through your financial records. 

A. How much money you’ve borrowed in the past. 

If you’ve borrowed a lot of money in the past, it could be a sign that lending you money could be a financial risk. 

B. Your credit score. 

If your credit score is low, it indicates that you failed to keep to repayment agreements you’ve had with past lenders. 

C. Your history with the financial institution. 

If you’ve been a long-standing customer, there’s a chance that your interest rates may be lesser than that of newer customers. 

D. The kind of loan you want to access. 

Short-term loans typically come with lower interest rates because when a loan is stretched over time, there’s a possibility that the borrower may not be able to return the money when due. Considering that the financial institution may have a lot of work to get their money back, interest rates may be higher. 

4. Government-backed loans 

Government-backed loans, also known as Federal Direct loans, are government-subsidized loans. Since citizens need access to funding for needs (like mortgage-backed securities including FHA and USDA loans, health loans, and student loans), the government takes away some of the stress of accessing these loans by offering subsidized packages. 

Interest rates on Federal Direct loans are lower than what you’ll get from other loan types. That’s because lenders, to some extent, are protected from defaults on payment of such loans by borrowers. In addition, borrowers typically get more time to pay off these debts. As a result, the financial obligations associated with these loans aren’t as dire. 

5. Competitor prices

The interest rates of other commercial banks also affect the interest rates of the financial institution you want to borrow from. If interest rates of other banks are low, there’s a possibility that interest rates of that specific bank would be lower as well. 

Banks also want to offer their customers fair deals. Hence, the competition also affects interest rates. 

Summary 

There isn’t exactly a one-size-fits-all approach to determining the interest rate for loans. However, consider all these factors we’ve discussed in the last section if you want a clear view of just how much you’d pay in interest. 

While at it, pay special attention to the part you have to play in determining how much your interest rate would be. Consciously work on improving your credit score and general creditworthiness. These are significant indices financial institutions evaluate before deciding whether or not they would lend you money. 

What we’ve discussed in this article is just an abridged version of how banks determine interest rates. For a more detailed walkthrough of how interest rates work, check out how banks set their interest rates.

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