Interest rates are the cost of borrowing money. They represent what creditors earn for lending you money. These rates are constantly changing, and differ based on the lender, as well as your creditworthiness. Interest rates not only keep the economy functioning, but they also keep people borrowing, spending, and lending. But most of us don't really stop to think about how they are implemented or who determines them.
This article summarizes the three main forces that control and determine interest rates.
- Interest rates are the cost of borrowing money and represent what creditors earn for lending money.
- Central banks raise or lower short-term interest rates to ensure stability and liquidity in the economy.
- Long-term interest rates are affected by demand for 10- and 30-year U.S. Treasury notes. Low demand for long-term notes leads to higher rates, while higher demand leads to lower rates.
- Retail banks also control rates based on the market, their business needs, and individual customers.
- Rates on individual loans are impacted by loan terms and credit rating.
Short-Term Interest Rates: Central Banks
In countries using a centralized banking model, short-term interest rates are determined by central banks. A government's economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so the supply of money within the economy is neither too large, which causes prices to increase, nor too small, which can lead to a drop in prices.
In the U.S., interest rates are determined by the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates. The actions of central banks like the Fed affect short-term and variable interest rates.
If the monetary policymakers wish to decrease the money supply, they will raise the interest rate, making it more attractive to deposit funds and reduce borrowing from the central bank. Conversely, if the central bank wishes to increase the money supply, they will decrease the interest rate, which makes it more attractive to borrow and spend money.
The Fed funds rate affects the prime rate—the rate banks charge their best customers, many of whom have the highest credit rating possible. It's also the rate banks charge each other for overnight loans.
The U.S. prime rate remained at 3.25% between Dec. 16, 2008 and Dec. 17, 2015, when it was raised to 3.5%.
Long-Term Interest Rates: Demand for Treasury Notes
Many of these rates are independent of the Fed funds rate, and, instead, follow 10- or 30-year Treasury note yields. These yields depend on demand after the U.S. Treasury Department auctions them off on the market. Lower demand tends to result in high interest rates. But when there is a high demand for these notes, it can push rates down lower.
If you have a long-term fixed-rate mortgage, car loan, student loan, or any similar non-revolving consumer credit product, this is where it falls. Some credit card annual percentage rates are also affected by these notes.
These rates are generally lower than most revolving credit products but are higher than the prime rate.
Many savings account rates are also determined by long-term Treasury notes.
Deposit & Loan Rates: Retail Banks
Retail banks are also partly responsible for controlling interest rates. Loans and mortgages they offer may have rates that change based on several factors including their needs, the market, and the individual consumer.
For example, someone with a lower credit score may be at a higher risk of default, so they pay a higher interest rate. The same applies to credit cards. Banks will offer different rates to different customers, and will also increase the rate if there is a missed payment, bounced payment, or for other services like balance transfers and foreign exchange.
For any individual loan, whether it be a personal loan or mortgage or corporate bond issue, interest rates may deviate from the baseline rates set by the processes above. For instance, a high-risk borrower with a low credit score will pay higher rates on a loan with the same terms as a low-risk borrower with a high credit score. In addition:
- Longer maturity loans will also have higher interest rates than short term loans.
- Loans secured by collateral will have lower interest rates than unsecured debts.
- Bonds with embedded options will have higher interest rates than those are non-callable.
The Bottom Line
Interest rates are determined, in large part, by central banks who actively commit to maintaining a target interest rate. They do so by intervening directly in the open market through open market operations (OMO), buying or selling Treasury securities to influence short term rates. These rates, in turn ripple out to inform many other rates on mortgage and auto loans to corporate bonds to bank deposits. Ultimately, the supply and demand for loans and credit in the market will dictate interest rates over the long-run.