How Does a Bank Decide What Interest Rate to Charge?

Over the last 12 to 18 months the banking world has been turned upside down by the global financial crisis. As a rule, banks obtain the money from a variety of sources and then lend that money to their customers at a higher rate than what they have paid for it. This is how a bank makes money.

A large part of the bank's resources comes from their deposit accounts. Things like everyday transaction accounts, term deposits and other investment accounts. They also borrow money from the Reserve Bank, and they have access to money from other banks, both at home and around the world.

As a rule of thumb, it is the cost of money from the Reserve Bank that determines how much a bank will charge its customers. This is because, in normal times, the Reserve Bank sets the interest rate after examining the state of the Australian and world economies and using its power to set the rate of interest as a method for controlling things like the growth of the economy and internal demand for credit. This rate has been an acceptable average for banks to use as a benchmark.

As the global financial crisis began to unfurl, the usual benchmarks flew out the window. No longer could banks use the reserve bank rate as their acceptable average. Instead they were forced to look at the internal costs they were incurring when borrowing money from other banks around the world. This international swap rate, as it is called, rose considerably, making that source of funding virtually untenable.

As the credit dried up, the amount of money the bank would lend similarly contracted. It was at this point that banks began to use different ways to determine the interest rate at which they could lend to borrowers. This accounts for the fact that each bank now lends at different rates for different home loans right across the board.

As a sense of calm gradually filters through the financial markets around the world, we can expect a return to the good old days. Until then, banks will continue to change the interest rates to match their internal costing, and not simply rely upon the Reserve Bank price of money.

There have been many criticisms in the press especially where banks have raised the interest rates by higher amounts than the reserve bank has set.

This is a brief explanation for why that has happened, and it is as good a reason as any to be careful when choosing which bank can give you the best deal on your home loan.

Richard J Gardner operates the Australian Bank Branches Directory which lists the location of all bank branches. Find the right bank branch and the best banking deals on home loans, credit cards and business lending at http://www.bankbranches.com.au

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