Interest Rates: What the Banks Do to Earn Money

It wouldn’t take too much of anybody’s time to figure out how banks earn money. Banks acquire cash from depositors and lenders (such as other banks) at low interest rates while they charge those that borrow that money a higher interest rate. The difference of the interest payment they made (which is very low) from the interest payment made to them (which is typically higher) accounts for their enormous profits

Interest rate is the cost of borrowing money. If you were used to the idea espoused by some that charging interest for money borrowed is a bad thing just as when borrowing is made between relatives or friends, you would be wiser to know that that’s just not how the business world works. There is a corresponding cost for having the benefit of using the money of others. How much this amount will be depends on a number of factors. One of the most significant of these factors is the perceived risk that the lender is taking on whether or not the borrower will be able to pay the money back. The higher the risk that the borrower will not be able to pay back, the higher the interest rate the lender will charge. 

Putting Cash at Risk
For people who don’t like to borrow money, the interest rate they would be familiar with is that which is earned by their savings deposit. Since the risk of defaulting is virtually zero for a bank, the interest rate of savings deposit is very low. Moreover, the low interest rate is also the cost of liquidity that is offered by savings deposit. In other words, since the depositor can withdraw his money anytime he wants, the funds are not as useful to a bank as compared with deposits made for the longer term. Banks are willing to pay more interest if the depositor will forego this freedom to withdraw such as the case with time deposits.

But even the 4% interest rate for a 5-year time deposit is paltry compared to the 26% effective rate of a personal loan charged by banks. It would seem that the banks are greedily taking advantage of unknowing borrowers but if we look further there are some factors that affect the ostensibly exorbitant interest rate. Foremost to these factors is what I have already mentioned which is the risk the bank is taking with this type of loan. Personal loans are considered unsecured because they are not backed by collaterals as opposed to a home loan, for example, which is collateralized by the house itself. The bank would take the house from the debtor in case of default.  This explains why banks would normally charge home loans with lower interest rates typically around 10% annually as against a personal loan.

Credit card debt is another type of unsecured debt the banks are happy to offer. Stories of people defaulting on their credit card debt is so common you can imagine the risk the banks are taking issuing these debts. But they are not ignorant of this fact that’s why they charge interests as high as they possibly can on these debts. This high interest rate has the dangerous potential of siphoning funds from a person undisciplined enough not to pay the charges due before deadline.

Consumer Protection
For people who doesn’t have a regular income or someone who has so little income he or she cannot pass the basic requirement of a bank for a personal loan, they fall prey to the all too popular scheme we call 5-6. “Five-six” means that for every five pesos borrowed; six pesos shall be paid back. This means that interest rate is effectively 20% which is paid on a monthly basis! This rate is several times over what the banks charge credit card debt and personal loans. 

But the fact that people are availing themselves of such credit scheme is testament to the lack of availability of funds for small-income individuals. Even with the enormous risk the lenders are taking, 20% interest monthly cannot possibly be considered a fair deal. The innovation of micro-finance and micro-credit which is becoming more popular is a step to address this problem. But a stronger government crackdown on unscrupulous lenders practicing this business model should be encouraged as well.