How Are Interest Rates Determined & Why Do We Need Them?
Interest rates are an integral part of today’s economy. They’re a financial instrument used not just by banks to offset risk but also by governments to control a variety of economic trends and maintain stability.
However, balancing the costs of borrowing money against the risks of lending money isn’t a straightforward process. The good news is that there are mechanisms for shaping interest rate changes and keeping them from negatively impacting the economy.
To help you better understand interest rates and how they work, let’s explore the underlying principles of how interest rates are determined, look at what factors determine interest rates, and explore why they’re so important.
The Importance of Interest Rates
To better answer the question of how are interest rates determined, it’s crucial to first understand the important role that they play in the economy. In the broadest sense, interest rates matter because they play a crucial role in the way that money flows in the economy. An increase or decrease in interest rates can either stimulate borrowing or spending or limit it, both of which can be useful in certain situations.
But in what situations do interest rate variations matter? Below are a few big ones you should know.
It Affects the Stock Market
Any changes in the interest rates have a crucial impact on the stock and bond markets, as well as the economy. Investors will often react to an increase in interest rates with caution, which can cause the markets to react negatively. Meanwhile, a reduction in interest rates will usually result in the stock market going up.
That’s because lower interest rates mean more money being lent by banks to businesses, which means more investment and growth opportunities. On the other hand, an increase in interest rates can mean fewer loans and slower overall growth.
Increasing Interest Rates Can Slow Down Inflation
To understand what determines interest rates, it’s crucial to clearly understand why they would be raised in the first place. After all, if borrowing money remains cheap, businesses can pursue more opportunities, which means more potential for growth.
However, the flip side of that equation is that unsustained and irresponsible lending can lead to inflation, which increases the consumer price index, meaning that people can buy less for the same amount of money.
By raising the interest rates, central banks can slow down the influx of money into the economy and as a result, reduce the rise of costs for people that can’t keep up with the growth.
Decreasing Interest Rates Encourages Spending
On the opposite spectrum, decreasing interest rates encourages businesses and consumers to spend and invest more, which typically results in faster growth and an increase in the price of assets.
Most central banks in the past few years have been much more willing to reduce interest rates or keep them low to encourage economic development and prevent stagnation. But low-interest rates, together with additional factors such as supply chain issues and the global pandemic, have resulted in inflation which may require raising interest rates in the near future.
Interest Rates Help Understand Other Economic Indicators
To better understand what factors determine interest rate changes, it’s a good idea to look at the broader picture of what the interest rates represent. This includes exploring common questions, like what are mortgage rates based on? When you combine the interest rate changes with other important economic indicators, you can get a more complete picture of what’s happening and what you might expect in the future. In fact, there are a few scenarios where the same interest rate changes could mean completely different things.
For instance, if interest rates are increasing while the GDP is decreasing, that means the economy might be heading towards recession, which might prompt the central bank to take action and potentially reduce the interest rates.
However, if the interest rates are decreasing and the GDP is growing, that is generally good news and shows that the economy is heading in the right direction. Still, this has to be measured against the consumer price index, which helps determine if inflation isn’t reducing people’s purchasing power. If that’s the case, the interest rates might need to be increased.
Who Determines Interest Rates?
When figuring out what determines mortgage rates, it’s also important to look at who determines interest rates in general. The main thing to understand is that there isn’t one single force that can explain the changes. In fact, three major forces can be attributed with influencing interest rates, each playing a different role, with some having a more short-term interest rate impact and others impacting the long-term interest rates.
Let’s explore each of these driving forces below.
The Federal Reserve
To start answering the question of what affects mortgage rates, it’s a good idea to start with the Federal Reserve. The Fed uses two primary benchmarks to determine what the short-term interest rates should be. These two benchmarks, called SOFR and prime rate, control both what it costs to borrow overnight and what banks charge their customers.
SOFR, which stands for Secured Overnight Financing Rate, is the rate that measures how much it would cost to borrow against the Treasury securities when using them as collateral. This used to be measured by LIBOR, but it was replaced by SOFR early in 2022 and is now updated every morning on the Federal Reserve’s website.
Meanwhile, the prime rate is the interest rate that banks typically charge their most trustworthy customers. It will always be above the base rate determined by the Federal Reserve but will still be lower than the average variable interest rate that banks offer.
But how can these benchmarks be used to understand what affects interest rates? These two benchmarks have ripple effects on the way banks lend and people or businesses borrow, which can be used to promote growth or stabilize the economy.
For instance, when the short-term interest rate increases, consumers and businesses have to recalculate whether their purchases or investments are feasible right now. At the same time, lenders have to evaluate whether a borrower can take on the loan with the increased interest rate. Over time, this tends to result in fewer loans being taken out.
On the other hand, if the Fed decreases the interest rate, that makes loaning money more feasible for consumers and businesses. And that usually results in more loans being taken out.
As mentioned before, variable interest rate changes imposed by the Fed through SOFR can also impact stock prices. Lowering the interest rate stimulates the economy and stock prices while lowering it typically brings stock prices down.
The Treasury
The next driving force that you should know when figuring out how mortgage rates are determined is the Treasury and the investors willing to invest in Treasury Notes. It has an impact on all non-revolving credit, which includes not just mortgages but also other consumer loans used for education, cars, or other big expenses. These types of loans will typically be given out for at least a year, but can also be lent for three, five, or even ten years.
The way the rates are set is based on Treasury Notes, which are sold at auctions to the highest bidders. If there’s high demand for these notes, then the yields investors can earn will be lower. If the demand is low, then the yield may be higher. The yield from these Treasury Notes is what determines long-term interest rates.
Banks
Banks can also have a big influence on the interest rates by using different types of variable interest rates and payment schemes. And unfortunately, the irresponsible application of some of these can put consumers in tough positions. To understand what mortgage rates are based on and how different variable interest loans can impact them, let’s look at a few examples.
Some of the interest rate types were developed to meet the new demands of consumers. For instance, in the housing boom early this century, rapidly rising housing prices incentivized consumers to take out variable interest rate home loans that were low in the initial years and rose much higher in the later years. The logic behind these types of loans was that the rising real estate prices would offset the increase in the interest rate and allow homeowners to sell their property for a profit in advance. Unfortunately, as the real estate market started to cool off, that was no longer possible.
Then there are loans that are bad from the start. Some banks have had practices of offering interest or even negative amortization loans. These loans didn’t allow the borrower to pay off the actual loan and would leave them paying off the interest, which would make getting out of the loan very challenging.
How Are Interest Rates Determined for Mortgages?
Many factors influence interest rates, especially when it comes to big-ticket items like mortgages. To help you gain a better understanding, let’s look at the main contributors and answer a few of the most relevant questions, such as how are mortgage interest rates determined for each person and does a down payment affect the interest rate?
- Credit Scores. When lenders evaluate what the interest rate should be in a specific situation, they will almost always look at the borrower’s credit score. It’s the most important measure that shows lenders how reliable a borrower is and whether the risk of lending to them warrants a higher or lower interest rate.
- Home Location. When figuring out what determines mortgage rates, it’s important to understand that location matters as well. Whether you are in a rural area or an urban area can have an impact on what interest rates the bank can offer you, although it’s a good idea to discuss with different lenders to see whether there’s a significant difference.
- Loan Amount. Sometimes, the loan amount can play a role in the type of interest rate you can get. Although it varies depending on the lender, loans that are unusually large or small can result in higher interest rates. On the other hand, if you cover more of the home’s value with your down payment, that may help reduce interest as well.
- Loan and Interest Type. There are many types of mortgage loans you could take out. As discussed earlier, the type of loan you take out based on your eligibility and needs will determine how high the interest rate is and how much of the loan you can pay back with each payment.
- Down Payment. A common question about mortgages is does a down payment affect interest rate? The short answer is that it can. A larger down payment can help you get a lower interest rate because it helps reduce the risk for the lender. If you can make a downpayment of 15-20% or even more, that can have a significant impact on the interest rate the lender can offer.
- Loan Term. Depending on what monthly payments you can afford, you should consider a shorter loan term if you want lower interest rates. While you will pay more each month, you can pay off the loan sooner, and the interest amount you end up paying will be lower.
Bottom Line
Understanding interest rates and how they work is crucial both for consumers and businesses. For the latter, it’s especially important because it enables companies to better predict how interest rates might change in the future and take advantage of better borrowing opportunities.At L3 Financing, we can help merchants access the best lending opportunities they can get. Our quick application process can allow you to receive quick merchant funding options that are best suited for your situation. Learn more about our services today!