How Interest Rates are Determined and Why They Can Vary

We’ve all seen headlines about “rising interests or falling rates,” but what does that really mean? Who sets interest rates? And how do you qualify for low interest rates?

Many of these headlines refer to mortgage interest rates rather than the interest rates on credit cards or personal loans. Let’s take a closer look at determinants of interest rates and why they vary.

What is an interest rate?

Simply put, an interest rate is the cost of borrowing money. It’s a percentage of the principal amount loaned and is influenced by factors such as your credit score. The total interest fee you pay, however, is typically expressed as the annual percentage rate (APR). An APR is often a bit higher than the advertised interest rate because it factors in other charges such as loan charges, origination fees and the length of the loan, but can give you a better idea of what the overall yearly cost of your loan will be.¹

How does the Fed determine interest rates?

The Federal Reserve System, or "The Fed," play a major role in what affects interest rates. The Fed lends directly to banks around the country, and also influences credit markets as a buyer and seller of U.S. Treasury securities. The Federal Reserve’s Federal Open Market Committee (FOMC) meets regularly to determine economic goals and policies about the availability and cost of money and credit.

The Fed's policies can impact short-term interest rates and long-term interest rates. If the FOMC wants to stimulate economic growth, they may lower interest rates to encourage consumers to borrow and invest. However, if rates are too low, it can cause excessive growth, which can lead to inflation. This prompts the FOMC to increase interest rates to slow growth and help prevent inflation.²

How do banks and financial institutions determine interest rates?

In general, banks and lenders can establish their own interest rates. However, they need to factor in the current market rate, their competitors’ rates and any policies or limitations set by the Fed. This helps them stay competitive and appeal to potential borrowers.

How are interest rates determined by a lender?

Many lenders decide your personal loan interest rate by looking at several factors:

• Credit score. A higher credit score lets them know that you’ve paid your bills on time, while a lower credit score tells lenders you may be a higher lending risk due to missed or inconsistent payments. Does your credit need some work? You may be able to reduce your interest rate by having a creditworthy cosigner. However, not all lenders accept cosigners.

• Credit history. Lenders want to see that you consistently pay your bills on time. The longer you’ve had credit, the better. A loan applicant with a short credit history can appear riskier than someone with 10 years of on-time payments.

• Creditworthiness. Your credit score and credit history work together in combination with other assets (like savings accounts and property equity). This determines your overall creditworthiness.

• Debt-to-income ratio. Your total monthly debt payments divided by your gross monthly income determines your debt-to-income ratio. Lenders use your debt-to-income ratio to measure your level of risk as a borrower.3 A person with a high debt-to-income ratio may seem high-risk to lenders because they’re already using a large percentage of their income to pay bills. These borrowers might be charged a higher interest rate on a loan, or their applications may be denied altogether. Lowering your debt-to-income ratio helps increase your chances of getting a better rate.

• Employment history. Lenders want to know that you can repay your loan, so they pay attention to your job history and your income. If you’re unemployed or have a lot of gaps in your resume, lenders may question your ability to pay your bill. That means you could have a higher interest rate on a loan than someone with a consistent income.

• Loan type. Depending on the lender, the amount of your loan request can impact your interest rate. The type of loan you’re applying for could also be a factor. For example, an installment loan has a fixed interest rate, but it could be higher than an adjustable-rate loan. Plus, some shorter-term loans could have a lower interest rate than those with a longer repayment schedule.

Getting the best rate on your loan

Ready to increase your chances of getting approved for a loan at the best interest rate? Here’s what to do. Get a free copy of your credit report and look out for any errors. If your credit score is a little on the low side, work to improve it prior to applying for a loan. Stay committed to your goals. Your hard work will pay off, landing you the loan you need with the best possible interest rate.

1. https://www.investopedia.com/terms/a/apr.asp
2. https://www.forbes.com/advisor/investing/fed-raises-interest-rates
3. https://www.consumerfinance.gov/ask-cfpb/what-is-a-debt-to-income-ratio-why-is-the-43-debt-to-income-ratio-important-en-1791/

This article has been updated from a previous posting on April 19, 2021. Melina Duffet contributed.