How are interest rates determined?

Friday, May 29th, 2009

How are interest rates determined?

How interest rates are determined

Interest rates, whether those that you are earning (deposit account) or paying (loan), are determined by a number of components. Here are the most important factors for each type of interest rate determination.

Savings and deposit accounts

The most important factor in deposit (e.g. savings account) interest rate determination is the competition. A related component is the institution’s need for deposits. These factors are really intertwined. For example, your bank or credit union wants to increase its deposits. It’s not difficult. They will offer deposit account interest rates higher than much or all of the competition. The money will come in, guaranteed.

If the institution has no specific purpose for more deposits, they will typically offer interest rates equal to the lower options offered by their competition. This reduces their “cost of funds,” which allows them to lower their loan interest rates or generate more profit.

Loans and lines-of-credit

Think of loan interest rate pricing as if you were managing a retail store. Your “selling price” (interest rate) is a combination of a) what you paid for the goods you’re selling (cost of money) and b) what the competition is charging. Loan interest rates are set based on the lender’s cost of the money and the rates their competition is charging.

If your bank or credit union is seeking new loans, they will typically lower their interest rates. Conversely, if they don’t need an increase in new loans, they will increase their rates to be slightly higher than competition. They may not generate many new loans, but they will earn more interest and generate higher profit per loan.

While the actual calculations are much more complicated, you now understand the basic theory used to set both savings and loan rates for every institution.

One Response to “How are interest rates determined?”

  • Vina Says:

    Thank God! Sonmeoe with brains speaks!

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