How Interest Rates and Loans Work From a Bank/Financial Institution Perspective

One of the main ways that banks make money is from interest earned from loans that they offer.

Banks use deposits from customers to offer loans to its customers.

These loans include mortgages loans, personal loans, business loans, car loans, etc.

That’s why most savings accounts from banks have an interest rate.

For example a bank can offer a savings account of 1% interest rate on amounts deposited.

Therefore if one opens a bank account, they would earn 1% extra of the amount they decide to deposit over a certain time.

When someone opens a bank account and deposits money into that account, it basically means they have loaned out the money to the bank, and the bank pays them an interest rate as a result.

Banks are only required to hold about 30% of the total amount they have in customer deposits as reserves, that’s why they are able to loan out huge amounts of money.

When an individual or a company borrows money from the bank, they are required to pay back the money through a pre-set timeline based on the term of the loan.

Sometimes the timeline could be for example 5 years, at an interest of 5% per year.

Meaning the borrower would need to pay the 5% every year for the 5 years, and in the last year pay back the last interest rate plus the borrowed amount, principal.

Sometimes the interest is fixed, meaning it remains constant through the set duration, or a variable interest rate, which for example would either increase or decrease every period based on certain loan terms.

When central banks raise the interest rates, financial institutions such as commercial banks would receive more deposits from customers due to the attractive rates they would acquire over time.

Banks gains in deposits would result in an increased amount of reserves, which they can use in other forms of investments such as purchasing of government bonds which have attractive rates as a result of increased interest rate.

Lowered interest rates from the central banks would mean that the banks would receive increased requests for different types of loans from customers.

When customers such as companies are able to borrow loans from banks at lower interest rates, it would mean that they are able to meet their customer needs efficiently and thus have higher chances of paying back the loans to the banks.

Generally, whether interest rates are increased or lowered, banks will always have ways of using them to their advantage, unless in times of financial crisis or extremely tough economic conditions.

The interest rates that banks use to offer loan services are set by the central banks of the countries in which these banks are located.

Central banks usually give a gap of the interest rates within which banks and other financial institutions can set their interest rates terms.

The gap is usually within a floor, the lowest interest rate the banks can offer, and a ceiling, the highest interest the banks can offer.

For example a floor of 1% and a ceiling of 10%, meaning the financial institutions could offer loans at interest rates not lower that 1% or not higher than 10%, but anywhere within the gap of 1% to 10%.

Due to the nature of the financial economy, banks within a country or region usually have their interest rates aligned at similar rates.

Big players in the financial industry usually have different ways through which they can adjust the interest rates to their favor based on certain advantages they may have such as high customer deposits, high levels of reserves, reputation, age of the banks, etc.

Banking policies require banks to have a certain reserve minimum of customer deposits in their account at all times.

When the reserve goes below the threshold, banks usually have the options to borrow from each other overnight at certain pre-set interest rates.

Central banks set this rate which banks use to borrow funds from each other.

In the United States the interest rates that banks use to borrow from each other overnight is referred to as Federal Funds rates.


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