Interest and fees charged on a loan have the effect of increasing the cost of an object or service purchased with credit. Various methods which are used to calculate interest rates can mislead a borrower about the actual cost of a loan. The interest rate that you pay to borrow money is influenced by numerous factors relating to the type of loan that you choose. The length of time over which a loan is to be repaid, the collateral, your credit history, and the lender that you select are all important aspects of the interest rate that you’ll be charged. However, rates are also influenced by factors outside the control of both the borrower and lender and unrelated to the specifics of a particular loan. Here are some of the key influences that go into determining the interest rate that you’ll pay:
- Economic conditions have an important influence on overall interest rates. Rates tend to increase during periods of strong economic activity when the demand for credit is high. A vital and healthy economy causes businesses to borrow funds in order to expand their output. At the same time, high employment rates and wage increases which accompany economic expansion usually make consumers more optimistic, leading them to buy more goods and services on credit. This increased demand for credit results in higher prices paid, in the form of interest rates, for that credit.
On the other hand, a weak economy does little to stimulate demand for credit by businesses or consumers. Industries operating at less-than-capacity along with rising unemployment cause cautiousness and cutbacks in spending and borrowing. The light demand for credit during these periods tends to drive interest rates downward.
- The inflationary expectations of consumers and businesses can have a major impact on interest rates. Lenders who foresee rising prices for goods and services will charge higher interest rates in order to compensate for the likelihood that their loans will be repaid with devalued dollars. At the same time potential borrowers, who are also anticipating rising inflation rates, are more likely to accept higher-interest loans because they expect to be able to pay them back with devalued dollars. The anticipation of rising inflation also stimulates consumers and businesses to buy as soon as possible in order to beat the expected price increases, placing more of a demand on credit which, in turn, drives interest rates upward.
- Policies and actions of the federal government can also be a major influence on interest rates. Large federal deficits that occur when expenditures exceed tax revenues require the government to annually borrow tens or hundreds of billions of dollars, which causes tremendous strains on the credit markets by taking lendable funds away from businesses and consumers. This increases the demand for credit and exerts upward pressure on interest rates.
The federal government continually intervenes directly in the credit markets to influence interest rates and guide the nation’s economic activity. This is done by the Federal Reserve Board (also known as the Fed), an independent agency headed by presidential appointees which acts as a banker to commercial banks. The Fed uses several tools to influence the credit markets: 1) the discount rate, which is the interest rate that commercial banks must pay when they borrow from the Fed. A change in the discount rate is likely to cause commercial banks to change the interest rates that they charge on loans made to businesses and individual borrowers. 2) The buying and selling of Treasury securities in the financial markets. These transactions have a major impact on the supply of money, credit availability, and interest rates. A large purchase of Treasuries by the Fed causes new funds to be injected into the banking system, which then has more money to lend, leading to lower interest rates. On the other hand, a large sale of Treasury securities takes money out of the banking system, causing banks to curtail lending by raising rates. 3) Public announcements by members of the Fed. For example, if a board member states that the Fed is concerned about rising inflation, interest rates are likely to rise in anticipation of the Fed’s efforts to restrict credit.
- A loan’s term, or maturity length, generally affects the rate of interest that will be charged. Loans with longer maturities typically have higher interest rates. A thirty-year home mortgage loan is likely to have a higher interest rate than a fifteen-year loan on the same property for the same amount. And a five-year car loan will carry a higher rate than a three-year loan. In short, a longer repayment period places the lender at greater risk.
- A borrower’s collateral can have a major impact on the interest rate charged by a lender. Collateral places the lender in a more secure financial position. In the event that the borrower doesn’t repay the loan, the lender can force the sale of the collateral in order to recoup any losses incurred. This lessens the risk to the lender, which should result in a reduced interest rate.