How Are Interest Rates Determined?

You may see headlines that mention “rising interest” or “falling rates.” These headlines highlight how interest rates can play a role when borrowing money with a personal loan, mortgage, credit card or other type of credit.

But what are interest rates, and how are they determined? And how can you qualify for a low interest rate when you need credit? Let’s take a closer look at how interest rates work and why they may vary.

What is an interest rate?

An interest rate is money paid to a lender for borrowing. That cost is added to the loan amount (called the “principal”) and is expressed as a percentage. The interest rate you’re offered is influenced by several factors, such as your credit score, payment history, the type of loan and market conditions.

In many cases, however the interest rate doesn’t represent the total cost of a loan or line of credit. The total cost is typically expressed as the annual percentage rate (APR). The APR is the yearly cost of a loan or line of credit, including interest and fees. Because the APR factors in these additional costs, an APR may be higher than the advertised interest rate.¹ Federal law requires lenders to calculate APR using a standardized method to make it easier to compare offers, even when loan terms are complex.

What determines interest rates?

Lenders set interest rates according to their own policies, but they are typically influenced by benchmarks set by the Federal Reserve (the “Fed”).

The role of the Fed in determining interest rates

The Fed sets the federal funds rate, which is the interest rate banks charge to lend each other funds overnight.² Lenders typically base their interest rates in part on this rate.

How lenders determine interest rates

In addition to the federal funds rate, lenders, banks and credit unions usually look to the rates charged in the marketplace and their own profitability when setting interest rates. Setting a competitive rate helps lenders appeal to potential borrowers.

Lenders also look at several of the applicant’s financial factors to determine the specific interest rate they’ll offer you, including the following:

Credit score

A credit score is a three-digit number that lenders use to assess how likely you may be to repay borrowed money. A higher credit score can mean a lower interest rate. There are several factors that can boost your credit score, like paying bills on time, paying down debt and limiting the amount of new credit you apply for.

Credit history

Lenders also look at your credit history in determining your interest rate. Your credit history includes factors like payment history, amounts owed and how long you’ve had credit. For instance, a loan applicant who just opened their first credit card may appear riskier than someone with 10 years of on-time payments.

Debt-to-income ratio (DTI)

Your debt-to-income ratio (DTI) measures your monthly payments on all your outstanding debts against your monthly pre-tax income. Lenders use your DTI ratio to assess your ability to repay what you borrow.³ A person with a high DTI ratio may seem riskier to lenders because they’re already using a large amount of their income to pay bills. These borrowers might be charged a higher interest rate on a loan, or their application may be declined altogether. Lowering your DTI ratio may help increase your chances of getting a better interest rate.

Income

Lenders want to know that you can repay your loan, so they pay attention to your job history and your income. If you don’t have consistent income, lenders may not be confident you can repay your loan. That means you could have a higher interest rate on a loan than someone with regular earnings.

Loan type

Depending on the lender, the amount of your loan request may impact your interest rate. The type of loan you’re applying for could also be a factor.

For instance, secured loans, which are backed by something of value that you possess, typically offer lower interest rates compared to unsecured loans because the lender has the right to take your collateral to recoup their loss if you default. Large, long-term secured loans like mortgages typically have lowest interest rates.

Co-borrower or cosigner

You may be able to reduce your interest rate by having a creditworthy co-borrower or cosigner. A co-borrower shares all responsibility for repaying the loan. A cosigner only becomes responsible if the borrower defaults. Lenders may have specific requirements for who can be a co-borrower or cosigner. Note that some lenders only accept co-borrowers, including OneMain Financial.

Getting the best interest rate from your lender

If you’re looking to increase your chances of getting approved for a loan at the best interest rate the lender will give you, there are a few actions you might take.

You can request a free copy of your credit report from each of the three major credit bureaus (Equifax, Experian and TransUnion) weekly via AnnualCreditReport.com. Review your reports for any errors such as a missed payment that you actually paid on time. Correcting mistakes may help improve your score.

If your credit score is on the low side, work to improve it prior to applying for a loan. Earning a higher credit score won’t happen overnight, so start early and stay committed to your financial goals. A higher credit score may help you get a better interest rate.

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Understand what shapes your interest rate

There’s a lot that goes into determining an interest rate, from broad influences such as the federal funds rate to individual factors such as your credit score. Understanding how interest rates are set can help you know what to expect when you’re comparing loans or lines of credit.

Sources

1. https://www.investopedia.com/terms/a/apr.asp
2. https://www.federalreserve.gov/monetarypolicy/fomc.htm
3. https://www.investopedia.com/terms/d/dti.asp

This article has been updated from previous postings in 2021 and 2022. Melina Duffet and Maureen Rayburn contributed.