Personal Loans

What Factors Affect Interest Rates

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 9 minute read

You have concluded that you need a personal loan for a good purpose and that you have a good chance of being approved. You are now prepared to move forward with the loan application process by investigating potential lenders. 

Of course, you should look for lending companies that are willing to work with customers like you by providing attractive terms and low-interest rates on personal loans. To save time and get quotations from several lenders in minutes rather than hours, you can use an aggregator like Credible.

You should also be familiar with the variables that impact the interest rate you receive on a personal loan. With this information in hand, you can take measures to strengthen your profile as a borrower before you ever apply for a loan, such as:

  • Reducing your credit utilization ratio can be accomplished by paying off revolving debt, including credit card balances.
  • Reducing your debt-to-income ratio may need exploring additional sources of revenue.
  • To locate valuables to use as security for a loan in order to avoid having the principle amount repossessed loan amount

The APRs vs. Interest Rates on Personal Loans

To start, it’s important to understand how APR differs from the interest rate.

Interest Rate

The annual percentage rate (APR) of your loan is the interest you pay on the loan’s principal. It is typically stated as a percentage, such as 6% or 8%. 

The compounding frequency determines how often interest is computed on the sum of the loan’s principal and accumulated interest, and thus the total numeric interest charge, or how much interest you may anticipate paying throughout the life of the loan if you don’t prepay. The total interest owed rises in tandem with the frequency of interest compounding.


The APR of your loan includes both interest and any fees you may have to pay. It’s also a percentage, and it always exceeds the interest rate on the loan. Borrowers of personal loans should keep an eye out for the origination charge, which is the largest fee of its kind and is calculated as a percentage of the loan’s principal and deducted from it before funding. 

For a loan of $10,000 principal plus interest with a 3% origination fee, the final amount that can be borrowed is $9,700 ($10,000 minus $300). Although borrowers with good credit histories may be exempt from paying origination fees on personal loans, borrowers with less than stellar credit histories may be required to pay these fees. 

The annual percentage rate (APR) will increase dramatically from the interest rate advertised if you are required to pay an origination charge. Before finalizing your application for a personal loan, you will have the chance to look over and compare interest rates and APR.

Potential Influences on Your Personal Loan Interest Rate

The following table illustrates the wide range of interest rates offered by various personal loan providers. Where does all this discordance come from? Such considerations are among the most important ones.

1. Lender & Credit Score

The interest rate you pay on a personal loan depends heavily on your creditworthiness as measured by your credit score. The borrowers each lender specifically targets are major contributors to the wide range of interest rates offered by different institutions. 

Lenders can be categorized as prime, super-prime, near-prime, subprime, or general, with the former focusing on borrowers with exceptional credit and the latter on those with fair or poor credit. It’s common for subprime lenders to charge greater interest rates than prime lenders.

Regardless, the FICO scoring algorithm is widely used by financial institutions to determine a borrower’s creditworthiness.

Elements of Your FICO Credit Score

FICO scores are widely used by lenders as a basis for their underwriting decisions. The five most important factors in determining your FICO credit score are, in descending order of importance:

  • A Record of Repayments. In terms of the FICO score, this factor accounts for 35%. The best strategy to maintain a high score is to pay all loans, credit lines, and non-debt commitments that can affect your score on time. This includes utility bills. If you can, sign up for automatic payments to eliminate the possibility of late fees. A seven-year history of your financial transactions is included in your credit report.
  • Leveraging of Credit. The percentage of your FICO score that this component makes up is 30%. It’s determined by dividing your total balances into revolving lines of credit (credit cards, lines of credit for home improvements, etc.) by the number of your available lines of credit. If you have $15,000 in total credit and $5,000 in revolving balances, your credit usage ratio is 33%. Credit utilization is expected to some degree, but lower ratios are preferred by lenders. Aim for a percentage lower than 50%.
  • Duration of Credit File. This component makes up about 15% of the total FICO score. When determining the length of your credit history, any open credit accounts older than six months are included. Closed accounts that were in good standing during the past 10 years and delinquent accounts that were closed within the past 7 years also qualify. The greatest strategy to score highly is to maintain dormant credit accounts for as long as possible.
  • Compendium of Credit. This factor constitutes 10% of your total FICO score. Credit card accounts are considered revolving debt by the FICO model, but installment debt, such as a fixed-rate auto loan, is considered less risky.
  • Brand New Credit. The last 10% of your FICO score comes from this factor. If you’ve just improved your credit score, it’s best not to apply for too many new loans or lines of credit all at once.
  • The rule of thumb is that the higher your credit score, the lower your rate will be. Super-prime borrowers (those with FICO scores between 740 and 850) can expect rates within 3% to 5% of their lender’s advertised minimum, barring the presence of major unfavorable characteristics in the noncredit component of their profiles. Borrowers with subprime credit scores (below 619) might anticipate interest rates in the upper half of their lender’s quoted range, e.g., above 22% in a 9% to 35% range.

Lenders’ Exclusive Scoring Models

Lenders employ credit and non-credit elements in their own unique scoring models, but rarely share the specifics with borrowers. Peer-to-peer (P2P) lenders such as Lending Club and Prosper are more forthcoming about their credit-scoring methods than traditional banks since they rely so much on the faith of individual investors.

Lending Club has a sophisticated methodology with 35 levels of risk assessment to grade loans. Both credit and non-credit information are used in its modeling. Grades range from A1 (lowest risk) to G5 (worst risk) on Lending Club. 

The effective interest rate for each tier is determined by the base rate plus an adjustment for risk and volatility that varies across credit ratings. Adjustment values range from 1.41% for A1 loans to 26.09% for G5 loans.

2. The ratio of debt to income

The debt-to-income ratio is calculated by dividing your total debt by your gross income. If your gross monthly income is $6,000 and your debt service payment is $3,000, your debt-to-income ratio is 50%.

You can include your mortgage loan and credit card payments when calculating your debt-to-income ratio. Utilities, which can affect your credit score in a positive way if you pay them on time, are not included in the calculation of total debt. You should simply plan to pay the minimum sum each month, even if you routinely run up greater balances on your credit cards.

Debt-to-income ratios below 43% are preferred by most mortgage providers. In general, the lower the ratio, the better it is for borrowers when applying for a personal loan.

3. Employment Situation & Earnings

Banks and other financial institutions are more likely to lend to those who can demonstrate a history of consistent employment and high income. The actual minimum yearly income criteria are often about $20,000, but low-income borrowers rarely qualify for the greatest interest rates. 

Creditors typically look at the last 24 months of employment but may go beyond if necessary. Traditional salaried workers are more likely to get approved for a personal loan from a lender than people who are self-employed, have a high percentage of their income from freelancing, or have recently established a small business. 

As a self-employed person with good credit, I can attest to the fact that self-employed borrowers are at a disadvantage; the interest rate I pay on a personal loan is several percentage points higher than that charged to borrowers with traditional jobs and the same amount of income, and some lenders won’t even consider my application.

4. Education

The relevance of the level of education while deciding whether or not to grant a loan can range widely. Non-conventional loan companies like Earnest and LendingPoint place greater emphasis on non-traditional credit characteristics such as education and job. 

Lenders of this type believe that borrowers in their twenties and thirties who have professional degrees and promising employment prospects are in a strong position to take on more debt despite their less-than-perfect credit.

5. Term of Loan

The interest rates on loans with terms of five to seven years are typically higher than those on loans with terms of one to three years. Overall, the cost of a loan increases with its term length.

6. Loan Amount

Since high-principal loans present more risk to lenders, they may have higher interest rates than low-principal loans. However, many loan companies will not approve borrowers for large principal amounts if they do not think the borrower is creditworthy. Loan amounts may be capped below what you’d want if your credit is only fair to good instead of exceptional.

7. Collateral

Interest rates for secured loans, or loans backed by collateral the borrower must give up if payments are missed, are typically lower than those on unsecured loans, which pose a much greater risk to the lender.

But most personal loans aren’t secured by any kind of collateral. Before applying for an unsecured loan to pay for an expense that could be financed by a secured loan, you should look into the secured loan possibilities.

Customers of both new and certified pre-owned automobiles typically use secured loans given by banks, credit unions, and specialized auto finance businesses to cover the cost of their purchases. 

Secured auto loans provide lower interest rates than unsecured general purpose loans, which could be used to fund a car purchase between private parties because the loan amount is secured by the car’s worth.

A secured auto loan that I obtained a few years ago cost me about a 3.3% annual percentage rate (APR), which was at least two percentage points less than the going rate for prime unsecured loans at the time.

8. Loan Goals

The rate that you pay on your loan won’t be based on the reason you’re taking it out. The lender does not have the authority to dictate how you spend the money you get as a result of your loan. The bank has to take your word for it that the loan would be used as you’ve described.

However, not all loan providers promote loans for certain uses. To see what I mean, go ahead and fiddle with the “Loan Purpose” column in the loan table we just created. Furthermore, there are a variety of situations in which a personal loan wouldn’t be the ideal option. 

For example, if you have great credit and a manageable amount of other debt, you might be eligible for a credit card balance transfer offer with a zero percent interest rate for a period of time that allows you to pay off the entire total. Even at a low-interest rate of 6% or 8% per year, a personal loan is not a good idea in that situation.

9. Benchmark Rates

Providers of personal loans don’t decide on interest rates in a vacuum. Like other banks, they respond to shifts in benchmark rates like the LIBOR by adjusting their retail rates (London Interbank Offered Rate).

The inflation rate and economic growth forecasts are two examples of the types of macro factors that influence benchmark interest rates. In a nutshell, interest rates tend to climb in times of high inflation and rapid economic expansion, and fall in times of low inflation and slow economic expansion. 

Following a prolonged period of low inflation beginning in late 2009 and ending in late 2015, the LIBOR progressively grew as prices soared, culminating at over 2.8% in late 2018. This is according to data from the Federal Reserve Bank of St. Louis.

Bottom Line

A borrower’s eligibility for a loan, the interest rate offered, and even the terms and conditions of the loan itself can be significantly impacted by seemingly little discrepancies in the scoring models used by different lenders. 

Do yourself a favor and shop around for the best personal loan rate by contacting as many lenders as you can. It’s possible that a substantial amount of information is just out of sight.

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