How Banks Set Interest Rates on Your Loans

When you go to a bank, you will find that each kind of deposit account comes with a different interest rate. According to the Federal Deposit Insurance Corporation (FDIC), accounts that usually earn the highest interest rates are money market accounts, traditional savings accounts, and certificates of deposit (CDs).

A bank earns what is known as a spread, which is simply the difference between what it earns on loans versus what it pays out as interest on deposits. The net interest margin (NIM) represents this spread.

Below is an overview of how a bank determines the interest rate for consumers and business loans.

Understanding Banks' Interest Rate Policy

Banks are generally free to determine the interest rates they will pay for deposits and charge for loans, but they must take into account competition, market interest rates, and Federal Reserve (Fed) policies. 

The Fed influences interest rates by setting certain rates, stipulating bank reserve requirements, and buying and selling “risk-free” U.S. Treasury and federal agency securities, which 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.

The 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. When the Fed institutes interest rate hikes, profits for the banking sector rise.

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—usually corporate ones—are based on Fed rates such as the fed funds. 

Other considerations that banks may take into account are expectations for inflation, money demand and velocity, and stock markets, among others.

Market-Based Factors

Banks look to maximize their NIM by determining the steepness in yield curves. The yield curve graphically depicts the difference between short-term and long-term interest rates. Generally, a bank looks to pay short-term rates to depositors, and lend at the longer-term rates. If a bank can do this successfully, it will make money. 

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.

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, like the Great 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-Based Factors

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 may come into play. 

For instance, how much a customer borrows, what their credit score is, and their overall relationship with the bank all come into play.

The amount of money used 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, they have sufficient “skin in the game” to not walk away from a loan during tough times. 

Collateral, or putting one’s other assets—such as a car, home, or other real estate property—down as backing for a loan, also matters. 

Loan duration, or how long it has until maturity, is important, as well. 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 on the U.S. Treasury Bill rate (a short-term government rate) and longer-term U.S. Treasury bonds. 

As rates on these benchmarks rise, so do the rates that banks charge. Other loans and rates include government-backed loans such as mortgage-backed securities, student loans, and small business loan rates, the last of which is partially backed by the government. 

When the government backs a loan, rates tend to be lower and are used as the basis for other loans made to consumers and businesses.

The Bottom Line

Banks use an array of factors to set interest rates. Effectively, they seek to maximize profits through their NIM for their shareholders. On the flip side, consumers and businesses seek the lowest rate possible. To obtain a good rate, one common-sense approach for getting a good rate would be to consider what a bank might be looking for when issuing a loan. 

Borrowers should consider factors they have significant control over, such as a high credit score, putting up collateral or a large down payment, and using many services from the same bank to get a discount. Borrowing during a down economy or when uncertainty is high could be a good strategy for achieving a favorable rate, especially if you 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.