What Determines a Bank’s Interest Rates?

What makes a bank’s interest rates rise or fall is a very important question to most borrowers. You may have heard about interest rates rising or falling, and wondered what determined that. For most banks, the interest rate set on their loans and deposits is determined by something called the prime rate.

The prime rate is a reference rate, or “base rate,” that is generally agreed upon by the top 25 commercial banks. Banks may price their consumer loans above or below the “prime rate” (usually above), but in general, the prime rate is used by most banks as a reference when setting interest rates on many of their commercial loans and some of their consumer loan products.

At any given time, usually a third of all commercial loans made by banks are priced off of the prime rate. However, how many loans are priced according to the prime rate can vary significantly due to a number of factors, such as the size or type of bank making the loan, the loan’s maturity, and whether the loan is secured by collateral.

Other factors that can influence a bank’s interest rate include the competitive environment in which they are making a loan, or the credit rating of the borrower. Riskier borrowers mean that the bank assumes more risk on whether the loan will be repaid, so they will price those loans accordingly. At the same time, banks must remain competitive for your business, so in a competitive environment, banks will price their loans lower – in the form of lower interest rates – in order to attract more borrowers.

How much of a profit margin the bank needs can also be a factor in determining interest rates. For instance, you may find better rates at a credit union, because credit unions are nonprofits that are owned by their member depositors. Therefore, they can afford to offer lower interest rates to their customers at the expense of higher margins.