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How Are Interest Rates Determined by Financial Institutions?

United States Treasury Building

As a finance professional, I am frequently asked “what is going to happen to interest rates?” The obvious answer is that interest rates are going to go up and they are going to go down. I just don’t know when they are going to go up or down. If I did, I would be a much wealthier person. The reality is that no one can accurately predict the direction of interest rates.

To be clear, the interest rates I’m talking about are consumer interest rates for both deposits (savings accounts and products) and loans. Within those two categories, there are scores of different interest rates for different accounts or products. Rather than getting into specifics, I will speak to interest paid on deposits and interest charged on loans.

Interest rates on different accounts or products do not generally move in the same direction, by the same amount, or at the same time. For example, the interest rate on 30-year mortgages could increase while the interest rate paid on six-month certificates of deposit might decrease. In short, there is not necessarily a direct correlation between the movement of interest rates from one account/product to the next.


How the balance sheet drives interest rates

One of the main drivers behind interest rates at a financial institution is the balance sheet. The balance sheet of a financial institution has assets and liabilities like any other business balance sheet. Unlike other businesses however, assets include loans and investments while liabilities are savings accounts and products. If that’s hard to understand, you can think of it like this: A loan is an asset for us because the amount we loan is owed to us by the members and the members are paying us for the privilege of borrowing it. A savings account is a liability on our books because it is the member’s money. We’ll have to pay the money back when they ask for it, and will pay interest for borrowing the money (so that we can loan it out to other members).

We use the interest income we receive on loans to pay interest on members’ savings. It is then my job to find a balance between the loan interest rates we charge and the interest rates we pay on deposits. This creates a balance sheet for the credit union that supports long-term financial sustainability.

In a perfect world, we would charge the lowest rates on loans and the highest rates on deposits. Because we don’t live in a perfect world and that strategy is not financially sustainable for the credit union, we get as close as we can to that ideal. We attempt to achieve equilibrium between loan interest rates that generate a return and support our operations, and deposit rates that pay a fair return and reward the member for participating in the cooperative.


How are interest rates determined?

We evaluate interest rates constantly, incorporating the following factors into our strategy toward sustainable banking.


Secondary markets

Interest rates on fixed-rate first mortgages are set daily and are determined by the secondary market. The secondary market comprises government agencies that buy mortgage loans from financial institutions. These include Federal National Mortgage Association (FNMA or Fannie Mae), Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), Government National Mortgage Association (GNMA or Ginnie Mae) and the Federal Home Loan Bank (FHLB).


Supply and demand

When the economy is performing well (GDP growth above 2%, low inflation, low unemployment) the demand for borrowing (loans) increases. A demand for borrowing can have the effect of increasing loan rates. The credit union might increase loan interest rates to slow down loan demand. They might also increase loan interest rates to maintain the spread between what we bring in on loan interest and how much we pay on savings accounts and products (this spread is referred to as net interest income).

To be able to fund increasing loan demand at higher interest rates, we may increase deposit interest rates to bring in more funds. However, increasing deposit interest rates doesn’t always mean we’ll grow more deposits. For example, we might decide to increase our rates on CDs to 4%, which is a great rate. By doing that, we may attract more deposits, but we also have to pay the higher 4% interest rate on all of those funds (i.e. our cost of funds—the interest expense we pay on member deposits—goes up). So, despite the fact that we’re attracting more savings, we’re also paying more to hold them. Which means we still may not have enough money to loan more to members who want to borrow. (This doesn’t mean we wouldn’t be able to cover members’ loans. We would have to borrow funds from another source, generally at a higher interest rate.)


The Federal Funds Target Rate

Another external factor that impacts interest rates is the Federal Open Market Committee (FOMC), commonly referred to as “The Fed.” The Fed controls the Federal Funds Target Rate and uses it as a tool to create monetary policy. The federal funds rate is the interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis. The Fed will adjust the Fed funds rate up or down depending on how it is trying to influence rates. The Fed funds rate can cause some consumer loan and deposit rates to change. Some money market account interest rates are tied to the Fed funds rate.



Many credit cards and home equity lines of credit tie the interest rate to the prime rate. The prime rate (prime) is the interest rate that commercial banks charge their most creditworthy customers—generally large corporations. The prime interest rate, or prime lending rate, is largely determined by the federal funds rate.

When the Fed adjusts the Fed funds rate, the prime rate moves in sync. But the rates (Fed funds and prime rate) are not the same. There is a spread between the Fed funds rate and the prime rate. For example, as of this writing, the spread between the Fed funds rate and the prime interest rate is 3%. The Fed funds rate is 1.75% and the prime rate is 4.75%.



Another factor impacting interest rates is competition. We look at our competitors’ (both banks and other credit unions) interest rates (both loans and deposits) every two weeks. We evaluate our position relative to our competition. We survey five banks and five credit unions for various loan and deposit interest rates. Though we take their rates into consideration, it is not our strategy to beat our competition on rates across the board. We may at times have the highest deposit rate for a certain product compared to the competitors we survey. Keep in mind that our competition is doing the same thing we are doing. They are also adjusting their rates, which means our relative position is always changing.


The stock market (not a factor)

One factor that does not impact our rates is the stock market. Almost all major stock market indices are up 30% for 2019. Although that is great, it has no bearing on market interest rates. In the past, when stocks rose, bond prices fell and yields increased. That correlation is not relevant in this environment. However, while stocks continue to rise, so do bond prices and for us, a rising stock market can mean that members are withdrawing their savings to invest in the stock market. We stick to our strategy of focusing on our balance sheet. We don’t raise deposit rates to keep the funds of members who would like higher returns offered by the stock market.

In summary, no one factor affects interest rates. It is a combination of many factors that involve maintaining balance.


Header image attribution: AgnosticPreachersKid / CC BY-SA


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Terry Field - Bio

About Terence Field

Terry Field is the senior vice president of finance at VSECU. In his role, he is involved with the other members of the Senior Management Team and members of the Asset Liability Management Committee in setting both loan and deposit rates. During his tenure at VSECU, Terry has seen the highs and lows of the interest rate cycles. When Terry isn’t trying to guess the future direction of interest rates, he is riding his bike in the summer and skiing in the winter.
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