How Interest Rates Are Determined

By Gregg Schoenberg Wednesday, July 27, 2011

If you are like most small business owners, then at some point in time you have had to borrow money from a bank or financial institution in order to support your operations. And, like many loan-seekers when they reach the end of the time-consuming and often-laborious process of obtaining financing, you may have thought to yourself, “What exactly determined the interest rate on my loan?”

For a lot of small business owners, this question remains largely unanswered as their focus returns to more pressing matters such as how they are going to use the money to grow and make their company more successful.

Given the mystery surrounding how interest rates are determined, and recognizing the profound impact that rates have on borrowers, it makes sense for all business owners to understand the forces that determine market interest rates.

There are two main factors that govern the rate of interest on a specific small-business loan:

  1. Creditworthiness of the borrower
    This is fairly obvious and easy to understand. If you always pay your bills on time, haven’t wracked up a lot of other debts, and have a proven business model, you are a more attractive (i.e. lower-risk) borrower and will thus be charged a lower interest rate than a higher-risk one.
  2. General level of market interest rates
    This is a bit less obvious and certainly harder to understand, so let’s take a closer look at the process by which those rates are set.

In the U.S., we first have to understand what happens at the Federal Reserve, our nation’s central bank. The Fed influences the level of interest rates for all types of loans by setting and periodically adjusting the federal funds rate. Without getting too technical, the fed funds rate essentially becomes the rate at which large banks can borrow money from one another for a short period of time. 

The rate at which banks can borrow affects the rates at which they are willing to lend, which of course affects the rates you can expect to pay when taking out a loan for your business.

Now that you understand how rates are set and who sets them, you may be wondering why they are set at a certain level and why they change, sometimes rapidly and dramatically, over time.

As the entity in charge of monetary policy and the setting of interest rates, the Fed has what is commonly referred to as a dual mandate: to maximize employment and to keep prices stable. If economic activity is sluggish and unemployment is high, then the Fed will typically lower the fed funds rate in order to encourage borrowing, spending, and investment, thereby stimulating the economy and reducing unemployment.  If, on the other hand, prices are increasing too rapidly, the Fed tends to raise the fed funds rate in an attempt to reign in borrowing and spending, thus driving prices down, or at least slowing their ascent.

If you think you may need to borrow money for your business in the not-too-distant future, or if you have outstanding debt that you are considering refinancing, it pays to keep an eye on the level of the fed funds rate and the direction that it has been heading. In a period of rising rates, it may make sense to secure your financing needs sooner rather than later, while in a time of declining rates, it may make sense to remain patient if you don’t need immediate funding.

Once you have decided that the time is right to seek a loan for your business, familiarize yourself with the current fed funds rate and make sure to ask different lenders how they plan to calculate the rate for your specific loan. Being aware of the benchmark interest rate, and understanding how lenders plan to use it to arrive at the rate for your loan, will help you to get the financing your business needs on the best possible terms.

*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.

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