What are Interest Rates and How are They Determined?

Planning to avail of a personal loan or credit card? If you’ve already started looking for options, you’ve most likely encountered the term “interest rate” at some point.

But what exactly are interest rates, and how are they determined? More importantly, what does it mean for your finances?

If you feel confused and overwhelmed as to how interest rates work, read this guide so you can better understand them and how they’re calculated.

What are Interest Rates?

Interest rates drive the economy and keep it moving. It’s why banks and financial institutions encourage individuals and businesses to avail of credit.

Interest is applied to various loan products—such as car, home, or personal loans—and credit cards. Borrowers pay interest rates in return for borrowing money.^[1] This is on top of the principal, or the original amount borrowed.

What, then, is the interest rate applied to banks’ bonds and savings accounts? You earn interest when you avail of such financial products. It’s what banks and financial institutions pay you for depositing your money with them.

However, this article will focus on interest rates for loans.

How are Interest Rates Determined?

Interest rates are influenced by the demand and supply of credit or funds in the money market.

If there’s an increased demand for money or credit, it will raise interest rates. A decreased demand will decrease interest rates.

Conversely, interest rates will decrease if there’s too much supply of credit. A decrease in the supply of credit, meanwhile, will result in high interest rates.

The direction that individuals, businesses, and governments take to save and spend their available funds influences the demand and supply of credit.^[2]

💹 How are Interest Rates Determined by the Bangko Sentral ng Pilipinas?

Contrary to what many believe, the BSP does not regulate interest rates imposed by banks and lending institutions. As mentioned, interest rates are determined by the supply and demand in the money market—and it has been this way in the Philippines since 1983.

The BSP is only responsible for setting overnight rates (the interest rate the central bank sets to target monetary policy^[3]) and the key policy rate (the specific interest rate that determines bank lending rates and the cost of credit for borrowers^[4]to maintain price stability).

The BSP allows the market to determine interest rates to prevent the reimposition of rate limits, which can lead to distortions or interference that significantly affect prices in the credit market.

However, the BSP can impose or regulate interest rates under extraordinary social and economic crises or conditions, like when it put a ceiling on credit card finance charges in 2020 during the COVID-19 pandemic.

BSP Benchmark Rate in 2024

The benchmark interest rate determines other interest rates. In a press briefing on February 15, 2024, the BSP Monetary Board announced that the country’s benchmark interest rate will stay at a 16-year high of 6.5% since risks to inflation have diminished and domestic activity prospects remain intact.^[5]

Factors That Determine Interest Rates

Various factors affect the level of interest rates, such as the following:

📌 Inflation

When inflation rates increase, expect high interest rates because banks and other financial institutions need a higher return on their investments. As a result, borrowers pay more than the principal amount.

📌 Economic Strength

A strong economy will require more goods and services. More businesses will try to meet this increased demand by borrowing more money, which can lead to high interest rates.

📌 Government Policy

The government is also a determining factor in interest rates since it creates or decides on economic policies. Increasing or decreasing interest rates helps create stability during inflation or boost the economy.

📌 Supply and Demand

As mentioned above, when the demand for credit is high, lenders increase interest rates for higher returns. But when the demand is low, lenders decrease their rates to attract more borrowers.

📌 Credit Risk

If banks or financial institutions deem you a high-risk borrower, expect to pay higher interest rates. Since they’re taking on a higher credit risk, lenders charge a base rate and a risk premium depending on the borrower’s profile.

📌 Loan Period

The duration it takes for a loan to be repaid also affects interest rates. Long-term loans like home mortgages or car loans come with higher monthly interest rates to help cover the lender’s risks for the duration of the loan.

Read more:

What are the Types of Interest Rates?

You need to know how to calculate interest rates per month to understand the actual cost of borrowing. However, you’ll encounter various interest rates with different formulas. Here are the most common types:

👉 Simple Interest Rate

Also known as nominal, basic, or regular interest, simple interest refers to the actual price you pay lenders without accounting for factors like time, payment schedule, or inflation. It’s the interest rate you often see advertised by banks and financial institutions.

How do you get the interest rate of a loan? Follow this simple formula:

Simple interest = Principal x interest rate x loan term

👉 Compound Interest Rate

Often called interest on interest, compound interest is calculated periodically, then added to the principal. A compound interest rate adds to the amount you owe.

Here’s the formula to compute compound interest rates:

Compound interest rate = [P (1 + i)ⁿ] – P

P = Principal

i = Interest

n = Number of compounding periods

👉 Effective Interest Rate

What is the effective interest rate on loans? It reflects the true amount you owe on a loan after adjusting for compounding. It takes into account the decreasing principal balance and any other upfront fees.

Effective interest rates are usually higher than simple interest and follow this formula:

Effective interest rate = (1 + i/n)ⁿ – 1

i = Stated rate of interest

n = Number of compounding periods per year

👉 Fixed Interest Rate

The interest rate stays the same until the end of the loan, regardless of market conditions, as long as you meet the lender’s conditions. However, they can be higher than variable interest rates.

Fixed interest rates are usually applied to loans and mortgages.

👉 Variable Interest Rate

As the name implies, this interest rate can change throughout the loan duration. For example, you can start out paying a higher interest rate, then pay a lower rate the following year. It’s usually based on fixed interest rates, adjusted using a benchmark rate.

👉 Accrued Interest Rate

This type of interest refers to unpaid interest and adds to the amount you owe on loans or credit cards.

👉 Annual Percentage Rate (APR)

What does APR mean? It stands for annual percentage rate.

In loans, it’s the yearly rate charged when you borrow money. It includes the interest rate on the principal loan amount and all other fees charged by the bank or financial institution.

👉 Monthly Add-On Rate

The monthly add-on rate is the total interest payable divided by the loan amount and multiplied by the number of months in your installment terms. It’s often calculated in advance and stays the same throughout the loan's lifetime.

👉 Annual Contractual Rate

Unlike the monthly add-on rate that remains the same even after every repayment, the annual contractual rate decreases as you pay back the money you borrowed. It’s computed based on the outstanding balance after every payment.

Read more:

Final Thoughts

Knowing what interest rates are and how they are determined is essential to managing your finances and making better financial decisions. Understand their critical roles in various financial products to enjoy their most significant benefits.

Apply for a UnionBank personal loan via Moneymax

Sources:

^[1] Why Should Interest Interest You? (Bangko Sentral ng Pilipinas)
^[2] Who Determines Interest Rates? (Investopedia, 2023)
^[3] Overnight Rate (Federal Funds Rate): Definition and How It Works (Investopedia, 2022)
^[4] Key Rate: Definition, Types, and Importance (Investopedia. 2023)
^[5] BSP keeps benchmark rate unchanged at 6.5% (Manila Bulletin, 2024)

A Beginner’s Guide to Interest Rates and How They Work

Rouselle Isla

What are Interest Rates?

How are Interest Rates Determined?