How Banks Set Interest Rates On Your Loans

On the face of it, figuring out how a bank makes money is a pretty straightforward affair. A bank earns a spread on the money it lends out from the money 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 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 bonds in existence) U.S. Treasury and agency securities to impact 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 at which banks trade balances (borrow and lend) with the Fed. 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, 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 discussed below.

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 a graphical 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, through making loans, 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, or the ups and downs in market rates, as an important factor banks look at. These factors all impact 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 rates to encourage customers to lend, or lower loan rates to incentivize customers to take on debt.