What is the Formula to Calculate Interest Rates?

Interest rate calculations are an important part of banking.

Though there is not necessarily a formula for calculating interest rates, there is a method that follows formulaic procedures. This is essentially the same as a formula, except it is more fluid.

Risk

Risk is the likelihood of a loan defaulting. Interest rates are partially adjusted for risk so that if a certain percentage default, the overall cost to the bank is still zero because everyone else's interest will cover the loss.

Collateral

Interest rates are also determined by what is backing them. A home loan, for example, has a home attached to it that can be sold for one lump sum in the event of default. An overdraft, however, does not and therefore will usually have higher interest rates.

Cost

Banks do not print money; they borrow the money, usually from other banks, that they lend. Therefore, the rate at which they borrow it also determines the rate at which they will lend it. This rate is influenced by market forces and the Federal Reserve, who buys and sells government securities to respectively lower or raise the interbank interest rate.

References

• The Federal Reserve Bank of New York: Interest Rates--An Introduction
• Investopedia: The Federal Reserve--Monetary Policy