Find out how banks decide what rate of interest they'll charge you on your mortgage, loan or credit card.
The way in which banks set your interest rate when you ask to borrow money is something of a mystery to most of us.
Banks’ interest rates can vary from person to person and from product to product. So what factors are really behind a bank’s decision to set the interest rate on your loan at 7%, or your credit card at 16.9%?
The Bank of England base rate
This is a rate that is reviewed regularly by the Bank of England and provides a benchmark that most banks factor in to their rate-setting decisions. However it is by no means a rate that banks must follow – if the Bank of England base rate falls to 0.1% your bank has no obligation to also drop the interest rate on your loan to 0.1%.
The LIBOR
The London Inter-Bank Offered Rate is the rate at which banks and other financial institutions lend to one another. It can have an effect on how your interest rate is set because it will govern how willing banks are to lend to borrowers – if the LIBOR is high, banks will be more likely to set their own interest rates high to compensate as it’s costing them more to finance your loan.
Your credit score
When a bank is making a decision on how much to charge you for any form of borrowing, they will pull together information from credit reference agencies to see what sort of borrower you are. If you are perceived as more of a high-risk customer you are likely to be charged more in interest, because banks will be less prepared to trust you to repay on time and in term.
Money available
The supply of money that banks have available also has a bearing on how much they will charge you or allow you to earn in interest. In times when the economy is slow and profits are dragging, banks will be less willing to lend out money. They have less to lend in the first place, and what’s more they will have less trust in borrowers to be able to repay. Therefore they will charge more interest on borrowing to recoup losses and set interest rates on savings lower.
FSA Regulations
New FSA rules put more pressure on banks when it comes to lending money. For example all banks must now hold twice the amount of money they have in reserve, meaning they have less to lend out and will be less willing to lend it out without a guaranteed return. Also the FSCS (Financial Services Compensation Scheme) now requires them to put more money into a scheme where every £50,000 saved per individual must be protected.
When deciding on an interest rate for any financial product banks will consider a mix of these factors, and arrive at a rate accordingly. That rate however is also open to change, as it can fluctuate at the bank’s discretion. Ultimately it is up to the bank to decide their interest rates, and though external factors have a bearing on this decision, the final say lies with the bank.
