Here’s What Really Goes On When Banks Set Interest Rates

aim darts shoot

makelessnoise via Flickr

Interest rates today are expected to remain at a low well into 2015, which directly influences consumers’ ability to earn decent returns on deposit accounts. Despite this reality, not many Americans truly comprehend how banks set interest rates and what factors play a role in how rates change.

Bank interest rates aren’t simply determined at the whim of any given bank or credit union, with no direction or benchmark.

On the contrary, there are a handful of key elements that sway interest rates today in consumers’ favour — or against it.

#1. Federal Reserve Requirements

The Fed enforces a minimum reserve requirement, also called a cash reserve ratio, on banks that are members of the Federal Reserve. These institutions are required to withhold a percentage of their liabilities in either a cash vault or in a Federal Reserve Bank at all times.

Each year, the Fed assesses how much in cash reserves financial institutions must set aside; the requirements are outlined in the Federal Reserve Board’s Regulation D.

Reserve percentage requirements are based on a bank’s net transaction accounts (such as checking accounts), which effective December 27, 2012, are as follows:

  • $0 – $12.4 million: 0% in reserves
  • $12.4 million – $79.5 million: 3% in cash reserves
  • Over $79.5 million: 10% in reserve requirements withheld

Why does all this matter? Banks that don’t have enough depositors to uphold their reserve requirement have the option to borrow funds from other banks through short-term loans to ensure the reserve requirement is met.

Banks are then charged by other banks interest on the loan, which is called the Federal Funds Rate — this cost of borrowing money is passed on to consumers via bank interest rates and adjustments on loan products like auto loans and mortgage loans.

#2. Discount Rate

The discount rate is another benchmark which determines how banks set interest rates. In addition giving banks the option to lend among one another, the Fed itself provides loans to help banks meet the reserve requirement at a “discount rate” for the loan.

This direct loan from the Federal Reserve is typically higher than the Federal Funds Rate, but has recently been lowered to supply institutions with a greater ability to provide loans to businesses and consumers. The lower the rate banks have to pay when borrowing funds from the Fed, the more affordable lending interest rates today are for consumers.

#3. Anticipated Inflation

When financial institutions determine the deposit and loan rates offered to customers, consideration is given to the potential inflation rate anticipated in the future.

Fergus Hodgson, Director of Fiscal Policy Studies for the John Locke Foundation in North Carolina, shares why this seemingly convoluted concept makes a great deal of difference on interest rates today.

“Inflation, the devaluation of a currency expressed in higher price levels, is one of two underlying drivers of retail interest rates — the other is the activity of the Federal Reserve system,” explains Hodgson. “In the presence of higher inflation, which the United States is beginning to experience, lenders need to raise their rates in order to generate a return. Relatively speaking, the money they receive when paid back will be less valuable, which offsets the interest rate charged.”

As lenders attempt to compensate for the rate of inflation, borrowers will likely continue seeing bank interest rates follow in suit.

“Consider a mortgage loan at an interest rate of 5 per cent, alongside an inflation rate of 2 per cent. The real interest rate or return to the financial intermediary is 3 per cent annually. If the rate of inflation were to rise to 5 per cent, the intermediary would need to offer comparable loans at a rate of 8 per cent for an equal return,” Hodgson illustrates.

#4. Demand For Loans

The fundamental idea of supply and demand resonates strongly with how interest rates are set as well. Since the economic recession, for example, fewer Americans have been financially capable — let alone willing — to take on large amounts of debt, such as a mortgage loan toward a home purchase. An over-saturated mortgage market (i.e. higher supply of mortgage loans) results in lower loan rates due to a lack of demand. The reverse also functions in the same way.

#5. Risk of Default

Lenders always take on a certain level of risk when lending money to borrowers. Those with a history of late payments or poor credit, for example, will likely exhibit the same dangerous financial behaviour with a newly acquired loan.

For this reason, bank interest rates are increased on loans by financial institutions in an effort to hasten and secure the return of their money in the event borrowers don’t make good on their promise to repay the loan within the pre-determined term.

While a lot of the factors affecting interest rates today are out of consumers’ immediate control, maintaining a clean line of credit and taking the initiative to shop around for the best bank interest rates in the area opens the door to interest rates on deposit and loan products that meet customers’ needs.

NOW READ: 21 ways rich people think differently >