Bank Interest Rates: Keep in Mind That Banks Are For-Profit Entities
What factors are considered when banks set their interest rates? Since their primary motivation is making a profit, banks set their interest rates in a way that benefits themselves. In order to lend money to other people, banks borrow money from other people. They make money by charging customers interest on loans, which is typically higher than the interest they pay back on their own loans.
From the perspective of the banks, there are a number of elements that contribute to the determination of interest rates. Here are some things they consider when a customer comes in to request a loan:
When deciding whether or not to grant you a loan, the interest rate is heavily influenced by the level of risk involved. What you can supply as collateral and your credit score are the two main factors that they use to assess the risk. Because of the greater likelihood of default, the bank demands a higher interest rate on high-risk loans from the outset. This ensures that the bank gets its money's worth.
The presence or absence of collateral is a factor that contributes to the overall risk. Home loans are often seen as less risky than other types of loans because the borrower's physical residence serves as collateral. If the borrower defaults on the loan, the bank can foreclose and sell the house at auction to recoup part of its losses. However, the lack of collateral for an unsecured loan like a credit card makes it more hazardous for the lender. For that reason, interest rates on credit cards are substantially higher.
The cost to the bank of lending you the money you seek is another consideration when calculating your interest rate. For the bank to stay profitable and avoid the risks mentioned earlier, the interest it pays to its borrowers determines the interest it charges to those borrowers.
Rivalry —Just like any other for-profit business, banks are always vying for a larger slice of the pie. Thus, the interest rates that other banks give to borrowers also have an impact on the rates that these banks offer to their own customers.
The prime rate is the interest rate that large banks are willing to lend their least secured funds to their best customers, as determined by the head of the Federal Reserve. Along with other variables like term length and risk, it is determined by the aforementioned competition and affects other loan rates.
The Federal Reserve buys and sells U.S. Treasury assets to affect bank prime interest rates; these rates, in turn, affect the tiny rates at which banks lend money to each other. However, banks often borrow millions of dollars all at once, rather than just tens of thousands. With a higher rate, the cost of borrowing money goes up and interest rates go up.
