How is my loan rate calculated?

Have you ever wondered how those seemingly random loan rates are decided upon? Is it purely a matter of the product providers trying to make as much money as they can? Well, yes, in a way it is. But it's not as simple as that. There is a lot of competition in the loan market, so the lenders have to carefully structure their products to attract borrowers whilst also making a viable profit and covering themselves for bad debt, which can be possible even with the most riskless customers, due to the vagaries of life.

It also depends on who the product provider is. If it is a bank or building society (i.e. not simply a specialist lender), then the lender will offer deposit accounts as well, and will need to pay interest on them. Banks in particular are constantly borrowing money and lending money to each other, and there is an accepted measure of the rate that they need to pay to do this. This is called LIBOR - the London inter-bank offered rate. The British Bankers Association set this rate, and then banks need to use this as the basis of the loan rates and deposit rates they offer.

At the moment, LIBOR is set at about 3.50. It is related to the Bank of England interest rate, which at the time of writing in mid-April is set at 3.75%. If LIBOR is set at 3.50, which it is at the moment, then it's a pretty safe assumption that interest rates will be coming down sooner rather than later, which could mean now is a good time to take out a loan or a mortgage. But you can also find out from the British Bankers Association website what the 1 month, 2 month or even 12 month LIBOR is. This is interesting, as at the moment, LIBOR's 1 month rate is 3.50, 6 month rate is less (about 3.35), but more at 12 months (3.75) which means the banks are predicting that interest rates will go down then go up again within a year.

When you see loan and mortgage rates, compare them to LIBOR, as that is a relevant benchmark. On top of LIBOR, the banks and building societies need to add a certain amount to cover their administration costs (including staff and property costs amongst others). Then they need to add what is known as a risk premium, which is an amount that covers the lender for the risk they are taking on the borrower. This alters depending on the borrower's credit history, credit score, the loan amount and the loan repayment length.

Finally, the lender will add an amount on top as profit. They'll do this whilst trying to remain competitive.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

© AskFinancially.com 2008

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