How are interest rates calculated?

2 Answers | Add Yours

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

A number of factors affect how banks determine the interest rates that they charge customers.  Some of these have to do with the supply of and demand for the money that the banks are loaning out.  Other factors have to do with the degree of risk that the bank incurs when it makes the loans.

In a market economy, prices are generally set through the mechanism of supply and demand.  This is somewhat true for the price of loanable funds.  The supply of loanable funds (how much a bank will be willing and able to loan at a given interest rate) is determined largely by the costs the bank has to bear in making the loans.  Banks often have to borrow money in order to lend it.  When they do so, they have to factor the cost of their own loans into the interest rate that they charge.  Banks also have various other costs associated with loans.  They have to pay their overhead costs and they have to spend on things like employee salaries for the time put into things like reviewing loan applications.  Banks will typically factor these costs into the price they charge to loan money.

Demand can also have an impact on the interest rates that banks set.  If the economy is booming and people are trying to borrow a lot of money, interest rates may go up as people compete to get loans.  Conversely, when the economy is doing poorly and fewer people want to borrow money, interest rates may drop.

A final factor that banks have to take into account is the risk inherent in a given loan.  Borrowers sometimes default on loans, meaning that the bank loses the money that it has loaned.  Banks try to make up for this risk by charging interest rates that are at least somewhat based on the level of risk for a given loan.  The more likely a borrower is to default (as based on things like credit ratings), the higher the interest rate is likely to be. 

All of these factors help to determine what interest rates banks will charge.  For more on this topic, please follow the link below.

Sources:
andreig's profile pic

andreig | eNotes Newbie

Posted on

Interest rates are calculated after a few variables :

1. Depending on the credit risk. Consumer credit or credit cards have a larger interest rate because they have a great payment risk from the loaned customer.

2. The amount of money the bank is willing to loan. Depending on market share and target, some banks are focused on home users others on business owners, corporate or investment. Corporate and investment banks will have a greater interest rates for small amounts of money but a lower one for big amounts.

3. The interest rates that the bank itself must make to cover all the requests. A bank might not have enough money to borrow from its own deposits. In this situation the institution is taking a loan from other banks. The interest rate will contain the interest rate that the bank itself will have to pay.

4.The refference interest rate from the Federal Reserve or National Bank. National Banks tend to set the trend with the interest rate that they pay the commercial banks to deposit the extra money at the State Treasury. 

5 The administrative costs of the bank. Rents, wages, software and security measures have an impact on the interest rate.

6. All the arguments above do apply to deposits even if my examples were focused on a credit situation.

We’ve answered 318,968 questions. We can answer yours, too.

Ask a question