Investopedia/Ryan C. Fuhrmann: How Banks Set Interest Rates on Your Loans

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How Banks Set Interest Rates on Your Loans
By Ryan C. Fuhrmann November 28, 2017 — 9:46 AM EST
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On the face of it, figuring out how a bank makes money is a pretty straightforward affair. A bank earns a spread on the funds it lends out from those  it takes in as a deposit. The net interest margin (NIM), which most banks report quarterly, represents this spread, which is simply the difference between what it earns on loans versus what it pays out as interest on deposits. This, of course, gets much more complicated given the dizzying array of credit products and interest rates used to determine the rate eventually charged for loans.

Below is an overview of how a bank determines the interest rate for consumers and business loans.
It All Starts With Interest Rate Policy

Banks are generally free to determine the interest rate they will pay for deposits and charge for loans, but they must take the competition into account, as well as the market levels for numerous interest rates and Fed policies. The United States Federal Reserve Bank influences interest rates by setting certain rates, stipulating bank reserve requirements, and buying and selling “risk-free” (a term used to indicate that these are among the safest in existence) U.S. Treasury and federal agency securities to 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.

A 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. Many other interest rates, including the prime rate, which is a rate that banks use for the ideal customer (usually a corporate one) with a solid credit rating and payment history, are based off Fed rates such as the Fed funds. Other considerations that banks may take into account are expectations for inflation levels, the demand and velocity for money throughout the United States and, internationally, stock market levels and other factors.
Market-Based Factors

Returning again to the NIM, banks look to maximize it by determining the steepness in yield curves. The yield curve basically shows in graphic format the difference between short-term and long-term interest rates. Generally, a bank looks to borrow, or pay short-term rates to depositors, and lend at the longer-term part of the yield curve. If a bank can do this successfully, it will make money and please shareholders. 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.

One academic study, appropriately entitled “How Do Banks Set Interest Rates,” estimates that 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, 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.
Client Inputs

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 come into play. For instance, how much a customer borrows, what his or her credit score is, and the overall relationship with the bank (e.g. the number of products the client uses, how long he or she has been a customer, size of accounts) all come into play.

The amount of money put down 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, he or she has sufficient “skin in the game” to not walk away from a loan during tough times. The fact that consumers put little money down (and even had loans with negative amortization schedules, meaning the loan balance increased over time) to buy homes during the Housing Bubble of the early 2000s is seen as a huge factor in helping to fan the flames of the subprime mortgage meltdown and ensuing Great Recession.

Collateral, or putting one’s other assets (car, home, other real estate) as backing for the loan, also influences skin in the game. The loan duration, or how long to maturity, is also important.  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.
A Summary of Different 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 trade off the U.S. Treasury Bill rate (a short-term government rate), the London Interbank Offered Rate (LIBOR) and longer-term U.S. Treasury bonds.

As rates on these market rates rise, so do the rates that banks charge. Other loans and rates include government-backed loans such as mortgage-backed securities (MBS), student loans and small business loan rates (SBA loans), the last of which are partially backed by the government. When the government has your back(ing), loan rates tend to be lower and are used as the basis for other loans made to consumers and businesses. Of course, this can lead to reckless lending and moral hazards when borrowers assume the government will bail them out when a loan goes bad.
The Bottom Line

Banks use an array of factors to set interest rates. The truth is, they are looking to maximize profits, through the NIM, for their shareholders. On the flip side, consumers and businesses seek the lowest rate possible. A commonsense approach for getting a good rate would be to turn the above discussion on its head, or look at the opposite factors from what a bank might be looking for.

The easiest way to start is from client inputs, such as having the highest credit score possible, putting up collateral or a large down payment for a loan, and using many services (checking, savings, brokerage, mortgage) from the same bank to get a discount. In addition, borrowing during a down economy or when uncertainty is high (about factors such as inflation and a volatile interest rate environment) could be a good strategy for achieving a favorable rate – choose a time when a bank may be especially motivated to make a deal or give you the best rate possible. Finally, seeking a loan or rate with government backing can also help you secure the lowest rate possible.
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