The federal government continually intervenes directly in the credit markets to influence interest rates and guide the nation’s economic activity. This is done by the Federal Reserve Board (also known as the Fed), an independent agency headed by presidential appointees which acts as a banker to commercial banks. The Fed uses several tools to influence the credit markets: 1) the discount rate, which is the interest rate that commercial banks must pay when they borrow from the Fed. A change in the discount rate is likely to cause commercial banks to change the interest rates that they charge on loans made to businesses and individual borrowers. 2) The buying and selling of Treasury securities in the financial markets. These transactions have a major impact on the supply of money, credit availability, and interest rates. A large purchase of Treasuries by the Fed causes new funds to be injected into the banking system, which then has more money to lend, leading to lower interest rates. On the other hand, a large sale of Treasury securities takes money out of the banking system, causing banks to curtail lending by raising rates. 3) Public announcements by members of the Fed. For example, if a board member states that the Fed is concerned about rising inflation, interest rates are likely to rise in anticipation of the Fed’s efforts to restrict credit.

A loan’s term, or maturity length, generally affects the rate of interest that will be charged. Loans with longer maturities typically have higher interest rates. A thirty-year home mortgage loan is likely to have a higher interest rate than a fifteen-year loan on the same property for the same amount. And a five-year car loan will carry a higher rate than a three-year loan. In short, a longer repayment period places the lender at greater risk.

 

A borrower’s collateral can have a major impact on the interest rate charged by a lender. Collateral places the lender in a more secure financial position. In the event that the borrower doesn’t repay the loan, the lender can force the sale of the collateral in order to recoup any losses incurred. This lessens the risk to the lender, which should result in a reduced interest rate.