When you go to a bank, you'll notice that different types of savings accounts have different interest rates. According to the Federal Deposit Insurance Corporation (FDIC), the accounts that typically earn the highest interest rates are money market accounts, traditional savings accounts, and certificates of deposit (CDs).
Banks earn a profit called the spread, which is simply the difference between the profit they make on the loan and the amount they pay in interest on the deposit. Net Interest Margin (NIM) represents this spread.
Below is an overview of how banks determine interest rates for consumer and business loans.
Key Takeaways
Banks earn a spread on deposits and loans. This is also called the net interest margin, and is the difference between the interest rate they earn on loans and the interest rate they pay on deposits. Banks are generally free to set their interest rates, but they must also take into account competitor interest rates, market levels, and federal policy. The Federal Reserve sets the federal funds rate to influence monetary policy. This is the interest rate that banks use when lending to each other and trading with the Fed. Other considerations that banks take into account when setting interest rates include inflation expectations, demand for money, stock market levels, and other factors.
Understanding Bank Interest Rate Policy
Banks are generally free to set their deposit and lending rates, but they must take into account competition, market interest rates, and Federal Reserve policies.
The Federal Reserve sets certain interest rates, stipulates reserve requirements for banks, and influences interest rates by buying and selling “risk-free” U.S. Treasury securities and federal agency securities, which in turn influences the deposits that banks place with the Federal Reserve.
This is called monetary policy and it aims to influence economic activity and the health and safety of the banking system as a whole. Most of the market economy countries have a similar type of monetary policy in their economies.
The federal funds rate is the interest rate that banks lend to each other, and the discount rate is the interest rate that the Fed lends to its member banks.
The primary tool the Federal Reserve uses to influence monetary policy is by setting the federal funds rate, which is the interest rate that banks use to lend to each other and transact with the Federal Reserve. When the Federal Reserve raises interest rates, profits for the banking sector increase.
Many other interest rates, including the prime rate that banks offer to ideal customers (usually corporations) with strong credit ratings and payment histories, are based on Federal Reserve rates, such as the federal funds rate.
Other things banks may take into account include expectations about inflation, money demand and velocity, the stock market, etc.
Market-based factors
Banks try to maximize NIM by determining the slope of the yield curve. The yield curve graphs the difference between short-term and long-term interest rates. Generally, banks aim to pay depositors short-term interest rates and lend at long-term interest rates. If banks can do this well, they can make a profit.
An inverted yield curve means that left-sided, or short-term, interest rates are higher than long-term interest rates, making it very difficult for banks to lend profitably. Fortunately, inverted yield curves are rare and don't usually last very long.
In the United States, the Federal Reserve controls monetary policy, while Congress controls fiscal policy, including taxation and government spending.
Banks determine interest rates based on economic factors such as gross domestic product (GDP), inflation levels, growth rates, etc. Interest rate volatility (the rise and fall of market interest rates) is also an important factor that banks take into account.
All of these factors affect the demand for loans, leading to higher or lower interest rates. When demand is low, such as during an economic downturn like the Great Recession, banks can raise deposit rates to encourage customers to lend, or lower loan rates to encourage customers to borrow.
Local market considerations are also important. Smaller markets may have higher interest rates due to less competition, less liquid loan markets, and lower overall loan volumes.
Client-Based Factors
As mentioned above, a bank's prime rate (the rate that banks charge their most creditworthy customers) is the best rate the bank will offer, and it assumes that there is a very high probability that the loan will be repaid in full and on time, but as any consumer who has tried to take out a loan knows, many other factors can come into play.
For example, the amount a customer borrows, their credit score, and their overall relationship with the bank all come into play.
The amount of money used as a down payment on a mortgage or other loan also matters, whether it's zero, 5%, 10%, or 20%. Research shows that when customers make a larger down payment up front, they feel more “equipped” to hold onto the loan if things get tough.
It's also important to have collateral – other assets such as a car, house or other real estate – to back the loan.
The term of the loan, i.e. the time until maturity, is also important. The longer the term, the higher the risk that the loan will not be repaid. That's why long-term interest rates are usually higher than short-term rates. Banks also take into account a customer's overall borrowing capacity.
For example, debt service ratios attempt to create one convenient formula that banks use to set the interest rates they charge on loans and pay on deposits.
Overview of different interest rates
There are many other types of interest rates and loan products. When it comes to setting interest rates, certain loans, such as mortgages, may not be based on the prime rate but on the Treasury bill rate (short-term government interest rate) or longer-term Treasury bonds.
When these benchmark interest rates rise, so do the interest rates charged by banks.Other loans and rates include government guaranteed loans such as mortgage-backed securities, student loans, and small business loan rates, which are partially guaranteed by the government.
When the government guarantees a loan, interest rates tend to be lower and are used as the basis for other loans to consumers and businesses.
What is a good credit score?
Your credit score affects many areas of your financial life, from the interest rates on your loans and mortgages to your success when renting an apartment. Credit scores typically range from 300 to 850, and the higher the better. The exact numbers that determine a good score can vary depending on the credit scoring model being used. However, a good credit score ranges from 670 to 739. A very good credit score is 740 to 799. Any score above this is considered excellent.
Can banks change interest rates on loans?
If the loan is a fixed rate loan, the bank cannot change the interest rate on the loan during the life of the loan. If the loan is a variable rate loan, the bank can change the interest rate on the loan. The interest rate change may be predetermined or it may track an index. Additionally, the terms of the loan may set a maximum increase.
How do banks determine interest rates for loans?
Banks set interest rates in line with those set by the Federal Reserve. They also take into account the interest rates charged by their competitors. For a given loan, banks consider a borrower's creditworthiness – their credit score, income, savings, and other financial metrics.
Conclusion
Banks set interest rates based on a variety of factors. Essentially, banks are trying to maximize profits for their shareholders through NIM, while consumers and businesses want the lowest possible interest rates. One common sense approach to getting a good interest rate is to think about what banks are looking for when they make a loan.
Borrowers should consider factors over which they have a lot of control, such as having a high credit score, offering collateral or a large down payment, and using many of the same bank's services to get discounts. Borrowing during an economic downturn or period of high uncertainty can be a good strategy to get favorable rates, especially if you pick a time when banks are especially motivated to close deals and offer the best possible rates. Finally, seeking government-backed loans and rates can also help secure the lowest possible interest rates.