How Do Banks Determine The Interest Rate?

13 August of 2014

Personal loans and mortgages certainly allow us to have things and do things that wouldn’t have been possible otherwise, but the interest can make a real dent in the happy feelings. Depending on the type of loan or product you’re talking about, interest may account for tens of thousands of dollars by the time the whole thing is paid off.

Of course, it isn’t just the amount or type of loan that dictates how much interest you have to pay. The interest rate is the real culprit, as even fractions of a percentage can make a monumental difference when it’s all said and done.

If you are like so many consumers, how those interest rates are determined is one of the great mysteries of life.

The Bank of Canada

Here in Canada, the rate you end up paying is likely to start with the Bank of Canada. They are an institution whose primary role is to set the interest rate they charge banks and other major financial institutions when they borrow money. This is known as the bank rate, and even though the Bank of Canada does set these rates, they don’t set the interest rates the average consumer pays on their loans.

A Handful of Factors

The interest rates that consumers pay are influenced by a handful of different factors. These include the bank’s current prime rate, the current rate of inflation, supply and demand or currency within the economy, the Bank of Canada’s monetary policy and the length of time that the money will be borrowed.

As an example, when there are more people out there that want to borrow money than want to lend money, there is less money to go around and the price of borrowing money increases, which means the interest rates increase. When investors see this happening, they want to invest more because they will receive greater return, and eventually the supply outweighs the demand and interest rates decrease.

The Borrower’s Perspective

Many borrowers aren’t particularly concerned with all of the behind the scenes details of how the interest rates are set and influenced. All they want to know is which real-world factors will affect the interest rate they have to pay. Some of these factors include:

  • The Loan Term – when a loan is shorter, such as overnight to about one year, the interest rate is usually less. This is because the lender can make an accurate prediction about market conditions that may make a difference. With longer term loans, than prediction ability isn’t the same, and the risk is greater, so the interest rate is higher.

  • The Risk – this often has to do with the credit rating of the borrower, as in do they have a history of paying loans back on time? If you’ve had issues in the past, a lender will feel the need to minimize the risk by raising the interest rate.

  • Inflation – a third factor that the average borrower may want to investigate is the current rate of inflation. This refers to a general increase in prices that makes lenders concerned about future price increases. Sometimes, if inflation has been relatively high, lenders will add to the interest rate to compensate for perceived inflation over the course of the loan.

Consumer Tips

It’s easy to see that many of the factors affecting how banks determine interest rates are completely out of your control. For these, there isn’t much you can do except wait until conditions are more favourable. However, there are some factors you do have control over and tips you can follow in order to get yourself the lowest interest rate possible. These include:

  • Shopping around to find a better rate. Not all banks have the same prime rate, and not all lenders charge the same interest rate. A very small difference in rate can make a big difference in how much you pay.

  • Stay on top of your credit. The lower the perceived risk of lending you money, the lower your personal interest rate will be. Always make your payments on time and keep your credit rating high.

  • Create a relationship with a specific lender. If you use the same lender for several different loans and products, they will come to trust you, and you might catch a break in terms of interest rate. And when you consider a mortgage broker, ask about the lenders they deal with and check whether they offer you a better deal. There are several mortgage brokers who specialize in debt consolidation through mortgage refinance. Make sure that the one you find is capable of providing a better service. 

  • Suggest a secured loan. Offering up collateral against the amount of your loan is a way to lower the interest rate you have to pay. This is another way of reducing the lender’s risk.

Author bio

Ricky Meyer is a professional finance expert with over ten years of experience in mortgage and financial consulting. He loves to write about all things finance. You can follow him at Twitter or Google Plus.

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