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Interest Rates Banks - How Do Banks Set Interest Rates?

federal loans mortgage loan

One of the most important factors in any economy is the current interest rate. In the United States, financial programs on the radio and TV report changes to the interest rate on a regular basis, and most knowledgeable consumers keep tabs on the rates. But for many people, interest rates and how they are set can be mystifying. Differences between bank rates, the federal interest rate, and current mortgage rates can add to the confusion, leaving many wondering if the process of setting interest rates has any rhyme or reason to it.

The key factor in all of the interest rates list above is the federal interest rate. This is the rate that most news programs are referring to when they speak of “the Fed” lowering or raising rates. The Federal Open Market Committee, which meets about every other month, determines how this rate will change. Contrary to the beliefs of many, this rate is not the current mortgage interest rate or a credit card rate, but rather is the amount that banks charge for over night loans to other banks. Therefore, the federal funds interest rate is not the rate that any public consumer will receive. However, this rate sets the general trend for other interest rates. If the federal funds rate goes up, then mortgage rates and other rates will do the same. If the federal rate goes down, so will the other rates.

Many banks take the money that they have been loaned at the federal rate and, like other companies, mark it up from the wholesale rate. Therefore, a bank that gets a substantial portion of its funds at the low federal rate will loan it to consumers at a higher rate. Therefore, the federal interest rate does affect the other interest rates. Banks determine their prices, just like most other business, in large part by how much they will need to mark up their product to make a profit. A bank will consider all of the risks and costs that it will assume when setting their rates. Most banks assume a certain number of their loans will not be repaid, so they factor that into their overall cost, along with salaries, overhead, marketing, and, of course, profit.

Banks also need to consider supply and demand when setting their interest rates. While supply and demand will also affect the federal interest rate, banks also need to take into account times when they will not have as many loan applications and adjust their rates accordingly.

Finally, different types of loan require different interest rates. For example, since auto loans are usually for much less and have a shorter term than home mortgage loans, banks will need to charge a higher interest rate to make a profit on them. However, while they can afford to charge a much lower rate of interest, mortgage loans are more profitable for banks in the long term since they are typically so much higher than auto loans and other personal loans.

Although many details of interest rates, loans, and economics can be confusing, a basic knowledge of how banks set interest rates will help the consumer understand the products and ultimately find a better loan for their needs.

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