Knowing how interest rates are determined is also useful for developing strategies to lower interest costs where possible and for knowing when the best rate has been negotiated for your situation.
Interest is the cost imposed on the borrower for the use of the lender’s money. It is typically quoted as a percentage of the loan proceeds on an annualized basis. The most elementary formula for calculating interest is:
I = PRT (Interest = Principal x Rate x Term).
In actual practice, lenders employ a variety of techniques to increase financing costs through calculation methods and payment schedules.
For example, most commercial lenders employ a 360-day calendar to calculate interest charges. This practice began before there were electronic calculators or computers, and determining interest charges was a time-consuming laborious chore. Rather than using a 365-day calendar, a 360-day calendar was justified to standardizing the months in to 30-day units, which made calculation much easier.
Conveniently, this shorter repayment calculation results in a slightly higher daily interest charge, which increases the costs to the borrower, particularly on long-term loans. Pennies quickly amount to dollars when looking at the cost of a loan in the millions.
Lenders typically base their interest rates on a number of factors, including their internal cost of funds, the degree of risk associated with the loan, and the length of time over which the loan is scheduled to be repaid. Each component is germane to the lender’s return on investment.