When contemplating taking out a loan either for a purchase or for debt consolidation, one question that the borrower should always ask is, â€œWhat is the interest rate?â€ The interest rate plays a big part in how much the item being financed will truly cost. The higher the interest rate, the more money a borrower pays over the lifetime of the loan.
That knowledge is basic financial literacy, but have you ever wondered how the interest rate is determined? My wife and I took out an unsecured loan to remodel our kitchen 15 years ago at an interest rate of nearly 15%, but recently we were offered a consolidation loan from our bank at 9%. My first car was financed at a rate of 8%, but my current automobile loan is 2.99%. How are interest rates set, and what makes them fluctuate?
The answer to those questions requires a three step process:
- Learn a little about how banks operate, and how they make money.
- Define the three fundamental interest rate types
- Connect how everything works together to set the interest rates for consumer loans.
Banks Borrow Money Too!
Banks make their money through the interest paid by consumers who have loaned money from them. Banks use the funds deposited by some customers, to borrow to others. However, a bank cannot loan out every cent on hand as it then may not be able to satisfy withdrawal requests if a large number of customers wanted cash at the same time. If a bank requires additional funds to fulfill loans, it will loan money from other banks or from a government entity called the Federal Reserve. Just like you and me, when a bank borrows money, it has to pay interest.
Interest Rate Types
Federal Funds Rate
Also known as the overnight rate, this is the rate at which banks borrow money to each other.
Federal Discount Rate
The rate at which banks can borrow directly from the Federal Reserve instead of from each other. This rate is typically higher than the Federal Funds Rate to encourage banks to borrow from each other before borrowing from the Federal Reserve.
The Prime Rate
Set by banks, and is the rate at which banks borrow money to their best customers. This rate may vary slightly from bank to bank, and is what most consumer loans are based upon. If you are considered at risk to default on a loan based on your credit history, your offered interest rate will be higher. The more risk you are perceived to have, the greater the amount added to the Prime Rate. The Wall Street Journal publishes the WSJ Prime, which is meant to be representative of what banks have their Prime Rate set to on any given day.
Tying It All Together
You’ve probably already heard of The Federal Reserve Board. The Federal Reserve Board, or The Fed for short, is a government banking institution in charge of monetary policy to help keep the US economy healthy. For example, if the economy is sluggish The Fed will lower interest rates to encourage spending. Because of the overall effect it’s decisions have on the nation’s economy, when the Federal Reserve Board takes action, it’s all over the news. We hear endless discussion regarding whether they will raise or lower rates.
When the Federal Reserve Board increases the Federal Funds Rate and the Discount Rate, it becomes more expensive for banks to borrow money. Banks will then pass that expense on to consumers by raising their Prime Rate, which in turn effects the interest rate on things people borrow money for every day.
Interest rates on automobile loans have been low for quite some time. For example, I financed my last vehicle with a 2.99% interest rate. If the Federal Reserve Board raises rates, automobile interest rates will also climb accordingly.
Credit Card Rates
Credit card interest rates are variable and based on the Prime Rate. If the Prime Rate goes up, your credit card rate will also rise. This means more will be paid in interest by the time the balance gets paid in full. The Federal Reserve changes interest rates infrequently, so one rate hike won’t make a huge difference. But with many rate increases over time, consumers could find themselves having trouble making progress in paying of their lines of credit because the majority of they monthly payments are simply going towards paying interest. Also, If rates start to increase, expect to see less of those 0% interest promotional offers.
Home mortgage rates are not tied to any of three interest rates listed above. Mortgage rates are set by Wall Street, but can be influenced by The Fed’s policies and what they say. If The Fed’s overall sentiment of the economy is positive, mortgage rates tend to rise. If the outlook is generally negative, home mortgage rates tend to fall.
If you already have a fixed rate mortgage, thereâ€™s nothing to worry about here as your interest rate would be unaffected by a rate hike by the Federal Reserve Board. However, those aspiring to buy a home in the near future should pay attention to what the Federal Reserve is saying about the economy, as it may be an indication as to whether interest rates may be going up or down in the near future.
Savings Account Rates
One of the few benefits to consumers of having the Federal Reserve Board raise interest rates is that it also causes savings account rates to go up. Current interest rates on savings accounts is a mere fraction of a percent. Money sitting in a savings account actually devalues every day because the interest earned is less than the rate of inflation.
To the average consumer, it may seem that interest rates rise and fall randomly. By understanding the Federal Reserve Board, and how their policies and decisions affect interest rates on every day financial products, consumers can make educated decisions regarding the best time to make a major purchase, or take out a loan that may enable them to enhance their life while minimizing the amount of interest to be paid.
Brought to you courtesy of Brock