Why interest rates are all over the mapWhy interest rates are all over the map

Interest rates and inflation are top of mind for all farmers at the moment. I recently wrote a post addressing interest rate risk, but I feel like now it’s time to answer an even more pressing question: Why are interest rates all over the map? How do lenders determine what to charge on each loan?

Risk-based pricing

Does every loan get the exact same rate? Speaking as a former banker I can tell you the answer: absolutely not. There are many variables that go into pricing a loan. Most lenders use “risk-based pricing” to determine how to price a product.

Loans with more stable collateral such as real estate have a lower interest rate usually than those with more volatile collateral, such as cattle. Individuals with a high credit score get better rates, as they are more likely to make their payments on time. You see where I am going here?

We all have heard of the risk/reward scenario. The riskier the deal the higher the reward, which in this case is higher interest to the bank. There is often a matrix where several different risk factors feed into an equation to determine the appropriate pricing in relation to the level of risk.

Source of funds

Lenders do not all get their money from the same place. A community bank gets money to fund a loan in a completely different way than a non-bank lending institution. Some money is tied to prime rate, some is tied to bonds, some is tied to independent investment funds, etc. Each source will have its own required rate of return, and this rate of return will determine how much the lender will charge the customer.

Related:Answers to 4 questions on interest rate hikes

If the money “cost them” 3% they have to charge more than 3% to make a profit. If the money cost them 5% they have to charge more than 5% to make a profit, and so on. So, it is not that one lender is gouging borrowers, or another is hardly making money. The rate to the customer depends on the lender’s cost of funds.

Rate lock periods

Let’s go back to risk-based pricing for a hot second. Rate lock periods are similar.

Rates fluctuate second to second in the market every day. The longer period of time associated with a fixed-rate period, the more risk there is of interest rate movement. So, the longer the lock period of a rate, the greater the risk. Risk/Reward scenario here we come again.

If you want to personally take less risk in interest rate movement and lock your rate for an extended period of time you will have to pay more. A 5-year lock is going to be cheaper than a 30-year lock. If you are risk-averse you would likely pick the 30-year lock and pay more for the peace of mind knowing your rate will not move. If you are not risk-averse and wanted to save some money, you would pick the 5-year and pay less but would be taking more risk.

Lock periods are a big difference in pricing a loan. Usually when you see an ad saying “Farm RE Loans starting at x%” they are usually showing you the lowest rate at the lowest lock period.

So, it is not that Lender Joe is gouging customers or Lender Jen is not making anything. There are a lot of behind-the-scenes calculations that go on for lenders to decide what to charge. They have to charge enough to be profitable above their cost of funds but also remain competitive.

Think about all that the next time you apply for a loan.

The opinions of the author are not necessarily those of Farm Futures or Farm Progress.