How banks set interest rate on your loans

August 9, 2017by Deep0

Whether an individual is applying for the loans today or has applied in the past or will in future, the interest rates may be different. Why? How does a bank set the interest rate for loans?
Following are some of the factors that influence the interest rate on your loans:

1. Base interest rate

The lending industry in your local market can decide whether the base interest rate is higher or lower than the national average.

2. Credit rating

The individual credit score shows how reliable the individual is, and it also represents how responsible you are with credit, it is a big part of the interest rate you pay. If the individual has a high credit score, then he is rewarded with a lower interest rate, because it will be seen as a lower default risk.

3. Tenure of loan

When an individual takes a long-term loan, the level of default risk increases. The bank takes on high interest rate risk. For example, if the bank gives 30 years fixed mortgage at 10% and the bank is borrowing at 7% and over 15 years there borrowing cost rises to 12%, so they could begin to lose money on your loan.

4. Market based factors

Generally, a bank takes into account the economic factors including the level and growth of GDP and inflation. The bank also looks the city’s interest rate volatility –the ups and downs in market rate. It will affect the demand for loan, which can help push rates higher and lower. Suppose an economy is in a recession so demand is low, at that time bank can increase deposit rate and encourage customers to lend, or lower loan rates to incentivize customers to take on debt.

5. Inflation

The high-interest rates curb inflation, but also slow down the economy and low-interest rates stimulate the economy, but could lead to inflation.

6. Cash Reserve Rate(CRR)

It is the percentage of cash deposits that banks need to keep with the RBI on an everyday basis. When CRR is increasing thenit means banks have lesser money to lend and due to that the interest rates also increase as the amount of liquidity in the financial system decreases.

7. Repo Rate

When the repo rate decreases, the banks can avail more funds at a lower interest rate and vice versa. Whereas, if the Reverse Repo Rate increases, banks lend more money to RBI because of the attractive interest rates that RBI offers to obtain the loans.
After accounting for the above factors, the banks or lenders decide their interest rates. As a borrower, one should compare rates offered by different lenders and take the final loan decision.

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