Why Do Higher Interest Rates Mean Higher Borrowing Costs?


When interest rates rise, banks have to pay more to borrow the money used to fund loans. Banks pass on that cost to borrowers in the form of higher interest rates on consumer and business loans. Other costs related to borrowing, such as taxes, appraisal fees and lender fees, are based on loan amounts rather than interest rates and are usually not impacted by rising interest rates.

Government Bonds

The United States federal government issues bonds, which are a type of debt instrument, to raise money needed for funding public works, the military and other federally-funded projects. Borrowers who are afraid that the U.S. may default on its debt payments demand higher interest rates on bonds during recessionary periods. Most mortgages are sold to investors as debt instruments; but because homeowners are viewed as more likely to default on debt payments than the federal government, mortgage rates usually stay at about 1.5 percent above the rate paid on 10-year government bonds. Therefore, when interest rates tied to bonds rise, borrowing costs rise for homeowners because mortgage rates have to go up to keep the margin between the two rates unchanged.

Financing Loans

Banks borrow money from the Federal Reserve and use those funds to write loans. Creditworthy customers normally pay the prime rate when borrowing money. The prime rate always remains at 3 percent above the rate it costs banks to borrow money from the Federal Reserve. This means banks make a 3 percent profit by borrowing money and lending it out. When the Federal Reserve raises the rate on interbank borrowing, the prime rate rises by the same margin which means borrowing becomes more expensive for consumers and businesses.

Credit Cards

Credit cards typically have interest rates tied to the prime rate. When the prime rate rises, credit card interest rates also rise. Cardholders, such as business owners who routinely charge certain costs to the card, suddenly have to deal with increased borrowing costs. Additionally, credit card companies can increase the margin between the prime rate and the interest rate paid by cardholders. If rates are rising, more cardholders are likely to have problems paying their debts. To mitigate the risk of borrower default, credit card issuers often increase interest rates on credit cards well above the increase in the prime rate. This can backfire because raising rates to offset possible losses can increase the likelihood of losses even further. However, despite the risks for the card issuer, it means increased borrowing costs for cardholders.

Other Considerations

Interest rates do not directly impact origination fees on loans or other processing fees. However, banks can raise those fees at any time as long as fees stay within legal limits. When rates are very high, lenders can make healthy profits just from investing in low-risk government bonds and therefore have little incentive to lend to consumers. Loans become more difficult to get, and underwriting standards are raised. Lack of competition means that lenders who continue to write high volumes of loans can raise processing fees because borrowers, unhappy about the fee hikes, have very few options.

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