Interest rates vary because individual lenders are free to set unique rates and terms. In a competitive market such as consumer lending, lenders try to differentiate their products by changing features to attract specific types of borrowers. Borrowers are free to shop among different lenders for specific rates and terms.
On a broad scale, the interest rate charged by a lender is influenced by the amount it costs the lender to obtain the funds. For example, a retail bank pays a small amount of interest to depositors who keep money in savings and checking accounts. The bank then takes this money and lends it to borrowers. The bank must charge borrowers a higher interest rate than it pays depositors. This difference (the “spread”) accounts for the primary source of the bank’s profit.
Other macro factors also affect the interest rates charged by lenders. Financial institutions in the U.S. are highly regulated and technical regulatory functions can alter the cost of lending. Tax laws can influence the ability and desire of lenders to attract new business. State-specific regulations can alter the cost of doing business and thus force institutions to adjust the minimum-required spread.
At a micro-level, specific factors of an individual borrower can change the interest rate offered on a particular loan. Banks have traditional used a “5-C” model of lending to estimate the interest rate offered to a borrower. The 5-Cs-credit, collateral, capacity, cash flow, character-can determine what interest rate is charged and whether a borrower will receive a loan. Traditionally, the 5-Cs have been used in corporate lending because the size of consumer loans do not justify the individualized nature of underwriting necessary to complete a detailed analysis.
For the consumer loan market, a consumer’s credit score has become the defacto method of pricing a loan. A credit score, which is a proprietary formula, is a single measure that lender can use to determine the amount of risk inherent in a consumer loan. Borrowers with lower credit scores are considered higher risk and are thus charged higher interest rates for their loans. Borrowers with high credit scores are considered low risk and are thus charged the lowest interest rates for their loans.
From a lender’s standpoint, the interest rate charged by a loan is capped primarily by competitive factors. If a lender charges a higher interest rate on its loans than a competitor, borrowers will flock to the cheaper competitor and the higher-priced lender will be pushed out of business. Conversely, if a lender charges an interest rate that is too low, it will be inundated with risky borrowers who default (i.e. do not repay their loans as agreed) and the low-priced lender will similarly be forced out of business. Thus interest rates become a balance between having too few customers and having too many risk customers.
As a borrower, variety in interest rates is a positive. This process rewards good borrowers who repay their loans on time and punishes bad borrowers who default on their debts. All borrowers can benefit by shopping for the best rates and terms and fully understanding the factors that influence interest rates in consumer loans.