How Banks Set Interest Rates on Your Loans – A Ready Reckoner

The process in which banks make money is pretty simple. First, they take in deposits from people like you and me. Then, they spread it around by lending it to other people in the form of loans. So, in order to make money, the banks set interest rates on these loans. The net interest margin or NIM is what they earn which is basically the difference between the interest they earn on loans and the interest they pay on your deposits. However, as simple as the process of how banks set interest rates sound, it’s not that simple. Interest rates depend on a lot of other factors.

Laying Down The Interest Rate Policy

Normally, banks are free to set the interest rates for deposits and loans. But that does not mean they can run amok. They need to keep their competition in mind and the rates that they are offering. On top of that, there are different market levels for various interest rates and Reserve Bank Of India policies that banks have to take into account.

The RBI influences interest rates by setting certain rates themselves, controlling the reserves that banks should maintain at all times and ensure that buying and selling credit is safe. Its purpose is to influence the general economy of the country and also to maintain a healthy market. The interest policy also includes something called the prime rate. This rate is offered to the ideal client with a solid credit score and financial history.

Banks also take into account factors like inflation, stock market levels, and other related things in order to finalize their interest rates. So, a lot of things goes into how banks set interest rates.

The Influence Of Markets On How Banks Set Interest Rates

Banks want to generate the maximum amount of NIM. In order to do this, they need to determine the difference between the short term and long term interest rates, usually in a graphic form. So, the bank will pay the short-term rates to depositors and lend money using the longer-term rates. This is what earns them the maximum amount of money. But this is governed by the ups and downs of the market and the economy. So, in case of a recession, banks usually increase the rate of interest on deposits so that people deposit more. As a result, they can lend out more and offer lower loan rates so that people continue to take loans.

Customers Influence Interest Rates Too!

Let’s come back to the topic of the prime rate. In a way, customers are the ones who influence the prime rate. This is the rate of interest that banks charge their most reliable clients. They are the most creditworthy customers with a perfect credit score and a flawless financial history. So, they will get the best rates that a bank has to offer because they are most likely to pay back the loaned amount in full within the time frame. But, in general, a lot of other factors are at play too. The rate of interest that a bank will charge you for a loan depends on the amount you borrow, your credit score and your relationship with the bank.

Then, there’s the amount of money that you put down as down payment. It’s very important to know that banks set interest rates by taking this into account. If you offer a large sum as a down payment, it proves you are credit-worthy. If you are putting up collateral like a house and a car, that too reduces your interest rate because it is improving your chances and also increasing your risks. The more you have at stake, the better it is for the bank. They have less to lose and hence charge a lower interest rate.

Then comes the duration of the loan. The longer your loan, the higher is the rate of interest. As a general rule of thumb, it is assumed that there is a higher risk of the loan not being repaid when it is being loaned out for a longer term. So, banks charge much higher rates of interest on such loans than short-term ones.

So, Should One Take Up A Loan From A Bank?

Banks definitely use a lot of tools and consider a number of factors to set interest rates. The truth, however, lies in the fact that they want to maximize their profits. But nowadays, as a customer should you opt for a loan from a bank?  You can opt for a FinTech company who can actually provide you the same loan at a lower rate and will not even discriminate based on your credit score. Sounds fair, right? These companies are far more approachable than your bank and definitely will try to provide you better and personalized service to meet your every need.


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