How Loan Rates Are Set

Posted By: Dr. Frugal in Loans on 08/29/2007 at 07:10:50

Many factors go into setting interest rates for various types of credit. Lenders have different motivations and different cost factors to consider. Here are some of the factors that go into setting various interest rates:

. Cost of money--All lenders must factor the cost of money into their equation. Banks have deposits, among other sources, they can use for lending, so there is a relationship between deposit rates and lending rates. Other lenders, such as credit card companies, often borrow money at a lower rate and lend it out to their customers. Retailers may have to use a commercial lending service.

. Degree of risk--The higher the risk to the lender, the higher it must set the interest rate. Credit card debt is risky because it's unsecured. There is a relatively high default and late payment rate. Credit card companies must factor these losses into their interest rates.

. Collateral--Loans with collateral (homes, cars) have lower rates than unsecured credit card debt and personal loans. Most home lenders require a down payment and want assurance that they can recover their money if the borrower defaults. Auto lenders have collateral--but unlike homes, a car can be driven away and difficult to repossess.

. Marketing--Some lenders use interest rates as a marketing tool to generate new business. Furniture and appliance dealers have done this for years (no money down! no finance charges until next year!). Automobile manufacturers and dealers use low interest rates to attract new buyers. In these cases, the lenders have factored the price of money into the product or they are willing to a hit on financing to gain some market share.

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