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April 2023

How Are Interest Rates Determined?

Close-up of LiveRamp stock chart affected by interest rates.
Last updated June 14th, 2024

Understanding interest rates is critical to understanding the cost of borrowing money. And homeowners thinking about remodeling projects and financing might well be wondering: How are interest rates determined?

Knowing how interest rates are determined helps borrowers make better financial decisions. A number of factors determine interest rates, including the bond market, inflation, and creditworthiness. Some, they can only observe, consider, and attempt to leverage as trends change. Others are personal factors they can act on immediately to boost their chances of getting a lower rate.

To properly service your clients, it’s vital to be able to explain interest rates and their part in personal finance. In this article, we’ll explain how interest rates are determined for customer home-improvement or remodeling loans.

Overview of interest rates

Let’s start at the core of finance. There are two main types of U.S. banking institutions: central and commercial. A central bank is a government-run bank that lends money directly to commercial banks, so that they can make loans. A commercial bank lends money to consumers.

At the top of the financial ladder in the U.S., we have the Federal Reserve System and the Federal Reserve Bank, collectively referred to as “the Fed.” The Fed’s Federal Open Market Committee (FOMC) governs U.S. monetary policy and sets the federal funds rate. Because other interest rates are based on this, the Fed can change that fundamental rate to slow down or speed up the economy.

The federal funds rate is also known as the “overnight loans” rate, which actually is a tight range of interest rates that banking institutions use to lend money to one another. Under certain conditions, the Fed also makes loans at this rate as a “last resort” to institutions having temporary problems obtaining them within their own market.

The Federal Reserve rate directly influences the next rung down the ladder: short-term interest rates. Short-term interest rates are the overnight rate that the Fed and banks use to lend money to one another. They are also the rates for government bonds and bills.

The third level, or rung, for rates is the “prime rate,” which is the rate that banks offer to their most reliable customers. The “prime rate” sets the standard for the consumer rates on revolving credit (like credit cards) and loans.

On the fourth rung down the ladder we find long-term interest rates. Long-term rates apply to things like 30-year U.S. Treasury bonds and mortgages.

Changes to the federal funds rate have a ripple effect on market rates, loan rates, and deposit rates for businesses, individuals, and households nationwide. When consumers borrow money, the interest rates are determined largely by the loan rates the lenders pay. Lenders, in turn, must charge enough interest to cover overhead and interest paid out on bank deposits and to make a profit.

The role of the bond market

The bond market is a key influencer in determining interest rates. When investors buy bonds, they’re lending money to governments or companies. Those interest rates pertain to interest paid to the investors, not by them. The interest rates that investors receive reflect the level of risk associated with the bond. Generally, the riskier the bond, the higher the interest rate.

Typically, when interest rates in general rise, bonds are more attractive to investors. As a rule, demand drives sales value. So when bond sales are strong, it creates pressure for lower interest rates. And the reverse is often true. When bond sales dip, lenders offer higher interest rates to entice investors.

In addition, Treasury department auctions commence weekly, monthly, and quarterly. This is when treasury securities are offered publicly at different target interest rates. These bills, bonds, and notes are used by the government to generate revenue and back the U.S. money supply. Treasury bonds/bills/notes come in various maturity terms, such as: one-, two-, three-, five-, seven-, and 10-year.

How are interest rates determined by inflation?

Inflation has a powerful, indirect effect on interest rates. Inflation is an incremental rise in the costs of goods and services, and it reduces the purchasing power of money.

When inflation is high, the Fed uses its influence to create higher interest rates. The higher interest rates make it harder for businesses and consumers to borrow money, so it slows down economic activity. often slow spending and increase investing and saving tendencies. Presumably this reduces inflation in the long run and builds currency value.

Conversely, when inflation is low, a lower interest rate is typically charged. Consumers therefore seek more loans, borrow more money, and incur more debt. Low interest rates may be great for borrowers, but in the long run they usually promote inflation. And the cycle begins again.

The role of creditworthiness

Creditworthiness affects interest rates for consumers as they apply for home improvement loans, car loans, and credit cards. Lenders assess the risk of default by borrowers before issuing a loan. This assessment includes the use of credit scores, which are based on the individual’s credit history. Similarly, corporate bond interest rates depend on how fiscally strong the issuing company is.

Consumer credit is determined in part using information from three credit bureaus: Equifax, Experian, and Transunion. These companies record credit data submitted by lenders and establish consumer credit histories. Based on payment history, credit utilization, credit mix, new credit, and the age of accounts, consumer credit scores are calculated.

Borrowers with strong credit histories and high credit scores typically receive lower interest rates. Borrowers with weaker credit histories and a low credit score typically are stuck with higher interest rates.

The bottom line

Nearly all economic components of almost any loan, purchase, savings, or investment initiative will be based at the outset on the federal funds rate. This includes prices, down payments and monthly payments on loans, even the interest yielded on an investment or savings account. There’s not much an individual consumer can do about that, other than let the information help guide their financial decisions. However, beyond that, their loan terms and rates are determined by things they actually can control on a personal level.

A person’s earning, savings, spending, borrowing, and repayment habits all shape creditworthiness. Healthy debt-to-income and debit-to-credit ratios; solid credit histories and reports; and accrued assets all represent potentially lower risk. Lenders who see minimal risk in a borrower can in turn offer lower interest rates and the most attractive terms.

Acorn Finance helps connect home owners and contractors with lenders when it’s time for home-improvement projects and renovations. Contractors seeking loans on behalf of their customers pay no dealer fees. Loans are available for up to $100,000, with terms to 12 years, and APRs as low as 6.99%.

With prequalified offers that don’t impact customer credit scores, and quick fund distribution, Acorn Finance does what others can’t. Check out the details and offers at https://www.acornfinance.com/.