Credit & Debt
Interest rates, explained
Interest is rent on money—the amount borrowers pay lenders for access to capital. Think of it as paying rent to live in an apartment or making lease payments to drive a car. Interest payments are basically fees which reflect the cost of borrowing money.
The question is: How much should you pay?
While borrowing money may seem as straightforward as filling out a loan application and agreeing on a rate, the process extends beyond any individual bank. At the very center of the financial universe is the Federal Reserve, which regulates the overall supply of dollars by setting rates at which banks can borrow from the government (discount rate) and from one another (federal funds). Its policies are administered through 12 regional reserve banks, which then deal directly with banks serving the public.
Once the Fed baseline is established, banks can calculate their own cost of capital and set a prime rate, the lowest rate at which they're willing to lend to their highest qualified customers. Prime serves as an internal benchmark from which lenders determine ranges for specific loan types like mortgages, home equity lines, auto loans and credit cards.
Finally, the lender considers your specific loan application. The most important task is evaluating your creditworthiness, or ability to repay the loan. Loan officers sometimes consider credit history, total amount of debt and reliability of income. Additionally, the bank must evaluate the quality of the underlying asset for which you want a loan (home, business equipment, car, etc.)
Setting an interest rate is ultimately about distilling several dozen variables into a single number. Before signing on the dotted line, consider what the loan will cost you, especially since interest can have a profound impact over time.
For more tips and resources on mastering your finances, visit chase.com/financialfitness.
Adam Johnson is a journalist and former business-news anchor at Bloomberg Television. He worked as an investment professional for two decades and writes frequently about business and finance.