Factors Affecting Bank Interest Rates

Written by christian koch
  • Share
  • Tweet
  • Share
  • Pin
  • Email
Factors Affecting Bank Interest Rates
Three main factors affect interest rates. (Comstock/Comstock/Getty Images)

The interest rates that one pays when borrowing money from a bank are sensitive to many factors. They respond to many factors in the broader economy. Banks and lending institutions are acutely aware of market rates and they always lend at a higher rate than they borrow. Understanding what affects these rates informs a borrower and helps her to make a good decision when borrowing money. Bank interest rates can be divided into three factor groups: systemic, bank and borrower.

Other People Are Reading

Systemic

The Federal Reserve Bank (The Fed) sets several key rates for interbank short-term lending including the Fed Funds Rate. This rate effectively sets the floor for lending. Most interest rates officially or unofficially follow the Fed rate, but Fed lending is only for large, systemically important banks, so the headline Fed target is usually a few percentage points below the retail lending rate.

LIBOR is the next level closer to the consumer. It is still an interbank rate, but smaller banks take part in the lending that determines LIBOR and it is higher than the Fed rate. LIBOR is a market determined rate that is considered a measure of systemic credit risk. During the late 2008 market meltdown, because there was so much concern about bank runs, LIBOR was as much as 3 per cent above the Fed rate. It is usually closer to a few basis points above, with 1 basis point equal to 1/100th of 1 per cent.

Bank

The size of the lending institution has an effect on the interest rate for a borrower. Banks lend in a chain, from the largest banks that can borrow directly from the government, to the smallest credit unions that borrow from regional banks. At each step in the process, a borrower pays a premium, in interest, to the lender. The smaller the bank, the more premiums have been factored into the money they lend. On the other side of the lending equation, banks that pay an interest rate on a CD or savings account derive this rate from their lending rate. They pay at their own lending rate less an operating spread, usually several basis points, to cover bank expenses.

Factors Affecting Bank Interest Rates
Smaller banks pay more to borrow the money they lend. (gold bank image by John Sfondilias from Fotolia.com)

Borrower

The systemic and bank factors create a floor for interest rates. Banks will always lend money for more than they borrow. What collateral is being borrowed against? Is the loan secured by a business or house? Is it a mortgage, a second mortgage, a line of credit? The more obligations there are against a piece of collateral, the higher the interest rate the borrower will pay. How leveraged is the loan? If the leverage is high, the interest rate will be high. Leverage is the percentage of the collateral a loan represents. For example, a £97,500 loan on a £130,000 house is 75 per cent leveraged. Banks like a borrower to have "skin in the game." They want the borrower to be motivated to make the payments. Longer loans represent a larger period of unknown and more time for something to go wrong. Shorter duration loans pay lower interest rates. The final determinant of an interest rate is the creditworthiness of the borrower herself. Someone who has never borrowed money before is an unknown borrower and carries more risk and will certainly pay a higher interest rate than a middle-aged bank customer who has repaid several car loans and one mortgage.

Don't Miss

Filter:
  • All types
  • Articles
  • Slideshows
  • Videos
Sort:
  • Most relevant
  • Most popular
  • Most recent

No articles available

No slideshows available

No videos available

By using the eHow.co.uk site, you consent to the use of cookies. For more information, please see our Cookie policy.