What Do Banks Charge to Lend Money to Consumers?

Effective debt management is key to the success of any financial plan. Through solid debt management, you can make timely bill payments, save on interest and even leverage credit to purchase assets that generate additional wealth. As part of wealth creation, it is critical that you first think of money as a product.

Identification

In exchange for offering consumer loans, a bank collects interest income on its investment. As with any investment, the bank expects interest payments, or returns, in accordance to risk. You are likely to pay higher interest rates if your credit is less than stellar. To negotiate lower interest rates, you may agree to secure your loan with collateral. A home mortgage is an example of a secured loan. After mortgage default, the bank can auction off your home for cash to make good on the missed payments and the balance. A bank will evaluate the strength of your personal finances before setting your interest rate. The bank offers the lowest interest rates to consumers who demonstrate the ability to pay bills on time and build savings.

Federal Reserve Board

The federal funds rate is a benchmark for interest rates on all consumer loans. Banks make overnight loans to each other at the federal funds rate so that each bank can meet its Federal Reserve requirements. For their consumer loans, banks charge rates above the federal funds rate. The premium compensates banks for the increased default risks that arise from dealing with consumers instead of other large financial institutions. In recession, the Federal Reserve cuts interest rates to encourage people to take out loans, spend money, and make investments. When the economy recovers, the Fed favors higher interest rates to guard a growing economy against inflation.

Fixed and Variable Rates

Loans are categorized into fixed- and variable-rate loans. With a fixed-rate loan, you lock in the same interest rate until you pay off the debt at maturity. A fixed-rate loan is ideal if you are a conservative borrower, who prefers to plan his budget around regular debt payments. Alternatively, a variable-rate loan charges different interest rates throughout its term, according to the prevailing interest rate environment. You may consider a variable rate loan if you expect future interest rates to decline.

Closing Costs

For larger loans, you are likely to owe closing costs. Closing costs help the bank process your application, hire lawyers to organize paperwork, and appraise loan collateral value. According to The Federal Reserve Board, you may owe 3 percent of your mortgage loan principal in closing costs.